Description

We are investors in financial sector securities with an emphasis on the middle tier of the capital structure (i.e., subordinated debt, preferred equity, and contingent convertible bonds).

Until November 28, 2018, the world hungered for floating rate debt.  November 28 was of course the date of Powell’s speech to the Economic Club of New York where he declared that rates were “just below the broad range of estimates of the level that would be neutral for the economy.” On top of an already strained market environment this sparked a rush for the exits in floating rate debt.  For example, the Invesco Variable Rate Preferred ETF (VRP) saw shares outstanding collapse from approximately 80MM on November 27 to 68MM today.  Forced selling by active and passive holders of floating rate securities facing outflows is causing dislocations in the floating rate space. 

One issue we find highly attractive in this environment are the Sallie Mae Series B preferred securities (Exchange Symbol: SLMBP).  The SLMBPs are perpetual preferred equity which pay a coupon of 3M Libor+170bps.  With 3M Libor at 2.78% and a price of 60.50 (on $100 par securities) this is a current yield of 7.4%.  On a fixed equivalent yield using the Eurodollar strip these currently trade at a YTP of 8.7% and its worth noting that the forward Eurodollar curve is exceptionally flat right now.  The Option Adjusted Spread as calculated by Bloomberg is a massive 484bps. For one point of reference, the BAC 4 Floater prefs which pay L+75 with a 4% floor trade at a yield today around 5% and an OAS ~300bps up from around 4.6% pre-Powell speech.

All of this on top of a decent underlying institution – Sallie Mae.  Sallie Mae is the leading student lender in the US.  It is quite profitable with a 1.68% Return on Assets and a 14.95% ROE in 3Q18.  It is well-capitalized with 11% Total Equity/Assets.  At Year End 2017, Sallie had a healthy Common Equity Tier 1 RBC ratio of 11.9%.

A few years ago, there were concerns that Fintech entrants would erode Sallie Mae’s market share and profitability but thus far it appears that those concerns were overblown with Fintech barely registering in terms of Sallie’s core market share.  There is no regulatory “hair” on Sallie Mae.  In 2014, Sallie Mae spun off from Navient which retained the run-off portfolio of FFELP loans.  Navient has subsequently run into issues with its servicing of federal student loans but this has no bearing on Sallie Mae.  Sallie Mae’s servicing infrastructure was designed ground up to be CFPB compliant and as such does not have legacy problems.

Sallie Mae is dedicated to the private student loan market.  As an underwriter, Sallie Mae has shown itself to be reasonably prudent.  Sallie avoids troublesome areas such as for-profit education.  Structurally, approximately 90% of SLM loans are co-signed with an average FICO of 747 (the higher of the borrower or the cosigner).  As a reminder, fair or not, it is exceedingly difficult to discharge student loans in bankruptcy. 

There has been a lot of discussion in recent years regarding the unsustainable growth of student loans.  Mathematically, tuition increases cannot outstrip nominal growth in perpetuity.  For our macro-outlook (insert grain of salt here) we assume that the total private student loan market and thus growth for Sallie Mae flattens in forward years. 

But we are credit investors not equity investors here and should welcome that outcome!  When capital intensive growth slows a company looks to capital return and these are expensive capital trading well below par.  A call at par is possible.  The SLMBPs are immediately callable on 30 days notice.  But given the relatively thin spread of L+170 at par I would consider a tender for these securities at a price in the mid-80s more realistic which is still 40% above current levels.  At a price of 85 Sallie Mae could record a sizable gain to book value by retiring liabilities at a discount and replace these securities with tax-deductible debt. 

Another potential catalyst for revaluation would be an acquisition of Sallie Mae.  Sallie has a commanding market share of US private education lending at 55%.  At this scale, unlike the vast majority of banks, Sallie actually has a non-commoditized franchise value.  Monoline product banks have an eventual tendency to be acquired by larger, diversified banks.  At approximately $4B of market cap, Sallie Mae is a digestible acquisition target by a range of larger deposit rich institutions. 

There will continue to be headlines about student loans.  While the risk of adverse politics/regulation is not zero, we do not consider it meaningful at these prices.  Private student loans exist because they fill a necessary need.  Moreover, outside of truly tail-event outcomes, even adverse regulation would be much more of a common-equity than a credit issue.  Not that we consider this a realistic scenario, but as a thought experiment posit an outcome in which all secondary education was free (i.e., government funded) in the US.  With no private student loan market, Sallie Mae would be in runoff/liquidation and we are buying securities here at 60 with a liquidation preference of 100.  Bring it on!

In short, these are very inexpensive floating rate securities providing fat yield for a good underlying credit with several realistic catalyst scenarios to make an additional 40%+ capital appreciation in the next few years.  The immediate opportunity exists because of indiscriminate forced selling out of variable rate investment vehicles to meet redemptions.  If you wanted to add floating rate credit to your portfolio, now is the opportune window to do so.

Catalyst

Sale of company

Tender for securities

Forced selling abates