While the stock market’s sell off in the early part of 2016 has reflected some market fear, the dislocation in various pockets of the high-yield corporate bond market has been much greater. Many articles have appeared in the financial media over the past several month discussing the structural changes to the bond market post the financial crisis that have made these markets less liquid as a result of both regulatory changes to the market. Generally, a less liquid market usually means wider spreads and more variance in dayto-day pricing, increasing price volatility. Based on what we have seen so far in early 2016, these observations seem to be on the mark, and we think that there may be significant opportunities in high-yield credit if recent market volatility continues to play out during the rest of the year. We have been buyers of corporate credit at various times in the past, but we rarely find issues that offer us the qualities that really makes us want to buy them – namely, the opportunity for equity-type (i.e., double digit) returns with low credit risk. Nonetheless, we often look at bond prices when we are researching equities, as credit prices can sometimes give us helpful insight into how the credit markets perceive the underlying businesses which can occasionally vary greatly from that of the equity market. When inquiring about credit prices in early 2016, we have often been surprised by the quotes we’ve gotten back. Often when we have asked for further color, we’ve been told that there is a “motivated seller” that needs to sell bonds – perhaps to meet redemptions or due to a ratings change for the bond. In some cases, there have been no ready buyers for these bonds, leading to lower prices.
We purchased two different bonds during February, although they are of very different profiles in terms of their potential risk and reward. Neither is a big position, as we were limited by the amount of bonds available at our preferred prices, but we think both are excellent investments and will contribute to the overall performance of the Fund.
The first is a fairly traditional bond issued by a company that is also represented in the portfolio as a small stock position. The company is a financial business, and despite owning a fairly unique collection of assets and a successful long-term track record is currently selling at a sizable discount to its tangible liquidation value. This is not altogether surprising, as most of the company’s operations compete in end-markets that are currently either out of favor or where near-term prospects look challenging. Nevertheless, we own a position in the stock because we believe there is significant long-term value and we don’t want to make the mistake of not buying an obvious bargain simply because we aren’t sure about the timing. On the other hand, the stock is currently a small position for us because we want to give ourselves the chance to take advantage of a better entry point if one comes along. Regardless of equity pricing, we believe the company represents a very attractive credit risk, and we were able to buy long-dated bonds during February at a cash yield greater than 8.5% and an all-in total return of close to 10% to maturity. We are hopeful that our combined position (stock and bond) will generate returns close to the mid-teens for us over a 2-3 year holding period, but if not we would expect to generate decent income on the bond component of the position while we wait for the equity to play out.
The second is a bond issued by Iconix Group, a company we are very familiar with, having owned the common stock twice in the recent past. Our track record on the equity is mixed: we made good money on it the first time we owned it as it de-levered coming out of the 2008-2009 crisis. The second time we sold at a loss as the company relevered into the easy credit environment of 2014-2015 and we became increasingly uncomfortable with the company’s debt profile as well as other issues, including some questionable accounting practices. Iconix has since replaced its management, but entered 2016 needing to roll out a maturing block of debt. Given the turbulent high yield market and the negative developments at the business, both the stock and bond were trading at prices that reflect a growing chance of bankruptcy risk.
Though the company carries more debt than is healthy, the underlying business is actually in pretty good shape, and the company generates substantial cash flow. We considered buying the stock, but despite a very depressed price we elected to pass due to our long-held aversion to owning equity when there is a large amount of debt in front of our ownership position. When we went through the various bond issues, however, we found a risk/return profile we could get comfortable with, and purchased junior bonds that come due in roughly two years. We paid 55 cents on the dollar, meaning that so long as the company remains solvent, we will make roughly double our money (including the interest we receive along the way). Our familiarity with the business gives us great confidence that these bonds are money good, barring some very low probability worst-case scenario. This isn’t a low risk investment, but we do believe we are being well compensated for the risk we are taking and we’ve sized the position appropriately to ensure that we will not suffer outsized losses if we are wrong.
The above post has been excerpted from a letter of Centaur Value Fund.
This report is being furnished by Centaur Capital Partners (“Centaur”) on a confidential basis and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. This report is being provided to existing limited partners for informational purposes only, and may not be disseminated, communicated or otherwise disclosed by the recipient to any third party without the prior written consent of Centaur.
An investment in the Fund (“CVF”) involves a significant degree of risk, and there can be no assurance that its investment objectives will be achieved or that its investments will be profitable. Certain of the performance information presented in this report are unaudited estimates based upon the information available to Centaur as of the date hereof, and are subject to subsequent revision as a result of the CVF’s audit. The performance results of CVF include the reinvestment of dividends and other earnings. Past performance is not necessarily a reliable indicator of future performance of CVF. An investment in CVF is subject to a wide variety of risks and considerations as detailed in the confidential memorandum of CVF.
References to the S&P 500, NASDAQ Composite and other indices herein are for informational and general comparative purposes only. There are significant differences between such indices and the investment program of CVF. CVF does not invest in all or necessarily any significant portion of the securities, industries or strategies represented by such indices. References to indices do not suggest that CVF will or is likely to achieve returns, volatility or other results similar to such indices.
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