Loan - Bond Relative Value

In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond.  For one company, Jarden Corporation, we showed that the bond's cost is 50 basis points higher than the loan's cost.  Since both debt instruments were issued by the same borrower, shouldn't they cost the same?

Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two.  This applies if you are looking at it from the perspective of the issuer or the investor.  For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).

Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. "high yield") bonds is typically higher than the yield on non-investment grade (i.e. "leveraged") loans.  This is because high yield bonds are more risky to own than leveraged loans, for these reasons:

1. Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured.  Thus, in a bankruptcy, the loans should get repaid before the bonds.
2. Maturity and Amortization:  Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years.  In addition, bonds typically have "bullet" maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time.  This longer maturity and lack of amortization make bonds more risky to own than loans.
3. Covenants:  Loans have more (and more restrictive) covenants than bonds.  Thus, as a company's operating performance begins to deteriorate, the loan will default long before the bond.  This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.

Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.

Issuer: Risk vs. Cost
As with Jarden,  for non-investment grade issuers, bonds typically have a higher all-in-cost than loans.  This is because bonds are less risky for issuers and provide issuers additional flexibility.

1. Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it.  If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk.  Companies can reduce their refinancing risk by issuing debt with longer maturities.  The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
2. Flexibility: Bonds place few restrictions on a borrower's operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.

Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.

Loan-Bond Relative Value

When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis.  In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.  

• If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.  
• If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.

Liquidity Position

There are lots of measures of liquidity. The classics are the current ratio and the quick ratio, but they've fallen out of favor because they don't include cash flow, a critical component of liquidity. Cash burn is too recent to be classic, even though it's been around for a while. But it's limited to on-balance-sheet sources of liquidity.

The liquidity position is the latest addition to the liquidity analysis toolkit. It has limitations, but we like it because it includes internal and external sources of funds. Here's a short slide show about it.

Hovnanian Takes a Half-Step in the Wrong Direction

Getting Better and Worse
The worst seems to be over for the housing industry in the United States. It may even be on the mend. In the competition for building sites, companies with less financial risk will have an advantage. Hovnanian Enterprises, the sixth largest homebuilder in the country, has been doing some interesting financial deals to improve its competitive position

Hovnanian had the highest leverage among its closest competitors. At the end of 2008, the company’s debt-to-capital ratio was 88.7%, while its rivals averaged 66.2%. With competitors buying foreclosed land from banks at historic-low prices, Hovnanian is forced to spend money on debt service instead.

Worse, Hovnanian had even less financial flexibility than the competition. Looking at maturities of debt over the next five years, Hovnanian had 28.3% of its debt coming due, while its competitors had only 23.0%. Worse still, the company’s debt was much more concentrated in a single year, as the chart below shows.

Maximum 1-year debt maturities as a percent of total debt are the highest value for debt maturities over the next five years as a percent of current period total debt.

Having so much of its debt maturities crowded into a single year is a problem for Hovnanian. It has a lot more refinancing risk than the companies it competes with. If its credit quality gets weaker or the capital markets take another dive when all that debt matures, Hovnanian will be in serious trouble.

Less Progress than Meets the Eye
To its credit, Hovnanian saw the problem and did something about it. Through exchanges offers, open market repurchases, and cash tender offers in the first three quarters of 2009, Hovnanian repaid $780 million of its debt. About $271 million of that was debt maturing in the next five years.

Unfortunately, Hovnanian’s efforts reduced leverage but reduced flexibility as well. Maximum 1-year debt maturities actually increased to 37.7% of total debt. The company had more success retiring its longer-maturity debt than the debt coming due in the next five years.

Financial leverage is a risk in its own right, but embedded in leverage is another risk: financial flexibility. And financial risks are closely connected to competitive risk. Good financial strategy manages all of those dimensions of risk effectively. Hovnanian seems still to be struggling to do that.