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2018.12.10 SNH 5.625% Sr Unsecured Notes Due 8/1/2042 Writeup

This is a very simple pitch so I will keep it incredibly short.  I recommend buying the SNH 5.625% Senior Unsecured Notes due 8/1/2042 (ticker SNHNI).  These are “baby bonds” that trade like preferreds with a $25 face value instead of $1,000 face value, but they are nevertheless bona fide bonds totaling $350 million face and not preferred stock. 

Here is a link to the supplemental indenture:

https://www.sec.gov/Archives/edgar/data/1075415/000110465912050176/a12-16695_1ex4d2.htm

Here is a link to the SNH Q3 supplemental: 

https://s2.q4cdn.com/659393127/files/doc_financials/supplemental/2018/SNH-_Q3-2018-Supplemental_FINAL.pdf

You can also see the baby bonds listed on the debt summary on page 17 – no differently than the other $1,000 face value bonds.

Despite having historically traded near (or even above par) and despite already being callable at par, these notes have traded off hard in recent months, largely in sympathy with SNH common stock.  SNH common has been under pressure for a number of reasons.  First, the GOV-SIR proposed transaction likely gave other investors in RMR managed REITs (of which SNH is one) some pause.  Second, SNH’s largest tenant is another RMR-controlled entity, FVE.  FVE’s recently adopted “going concern” language has driven newfound concern over the sustainability of SNH’s common dividend, potential accommodations or investments SNH may make with regard to FVE, etc.

However, I believe this is all largely beside the point for the SNH baby bonds.  I believe the raison d’etre of SNH is to generate fees for RMR.  Importantly, I believe this means continuous access to the unsecured bond markets and maintenance of investment grade ratings.  I believe RMR has demonstrated that when maintenance of investment grade ratings is called into question for its large Managed REITs, it will take action to protect said ratings, at the expense of common shareholders of the applicable Managed REIT, if necessary.  While such actions (common dividend cuts, asset sales, take-unders/mergers, etc.) may be negative for common shareholders of the given Managed REIT, I believe they are “credit positive.”  So in short, I believe that the concerns reasonably responsible for SNH common’s recent sharp decline are a non-issue for SNH bondholders.

Among the different pari passu SNH bonds, I believe the 5.625% baby bonds are the most attractive.  They trade significantly wide of the regular $1,000 face bonds.  For instance, the longest dated 4.75% bonds due 2/15/2018 are quoted at ~95 cents on the dollar, or ~5.4% YTM.  Meanwhile the 5.625% baby bonds are trading at ~80 cents on the dollar, or ~7.5% YTM.  If the baby bonds were to trade back up to par over the next 12 months to a ~5.6% YTM, we’d be looking at a total return of ~30%.  If it takes 2 years, we’d be looking at a total return of ~36% over the 2 years. 

Another key comparable security is the other SNH baby bond issue – the 6.25% due 2/1/2046 (ticker SNHNL).  These also traded down in concert with SNH common in recent months, though not to the same extent as the 5.625% baby bonds I’m recommending. The 6.25% baby bonds now trade at ~91 cents on the dollar and ~7.0% YTM.  With a lower dollar price and higher YTM, I believe the 5.625% are more attractive.

Besides some relatively standard REIT bond incurrence covenants, these bonds also have a maintenance covenant – essentially requiring SNH to maintain Total Unencumbered Assets >1.5x Unsecured Debt.  While the definition of assets is rather loose in that it is based on historical cost instead of market value, it is still a modest benefit (and not something typically seen in investment grade bonds trading at 80 cents).

Only the baby bonds are trading like they’re stressed.  I believe this is technical and not fundamental.  Over the course of the next several months / quarters, I suspect the baby bonds trade back up towards par and reverse the large spread that has opened up between them and the other pari passu bonds, generating a nice total return with relatively minimal fundamental credit risk.  Of course, for those concerned about credit risk, shorting the long dated $1,000 face bonds against these baby bonds would be a reasonable relative value option – as these baby bonds are off ~4-5x as much in % terms as the 2028s and off ~15x as much as the 2024s.

Catalysts

Time passing

Tax loss selling season ending

SNH common dividend cut

FVE accommodations are announced and its going concern language removed, or FVE fears are otherwise resolved

Asset sales

Catalyst

Time passing

Tax loss selling season ending

SNH common dividend cut

FVE accommodations are announced and its going concern language removed, or FVE fears are otherwise resolved

Asset sales