Description
Van Kampen Dynamic Credit Opportunities Fund (VTA)
Closing Share Price: $7.05
Closing NAV: $8.16
Premium/(Discount): -13.97%
Monthly Dividend: $0.1278
Current Distribution Rate: 23.10%
52 Week High-Low: $16.48-$5.56
Fund Sponsor: Van Kampen
This is a recommendation to go long a closed-end fund which invests in senior secured bank loans. Also known as leveraged loans, these are mostly first lien, floating rate instruments issued by non-investment grade (or barely investment grade) companies which have relatively high levels of total debt. The loans are secured by all of the issuers’ assets and must be repaid first in the event of bankruptcy. VTA is one of about twenty such closed-end funds whose underlying assets have very similar characteristics. They are listed on major exchanges, have a fixed number of shares, and can trade at a discount or premium to Net Asset Value (NAV). A good summary is found at www.ETFconnect.com (select Find a Fund; select Other-Loan Participation).
Description:
VTA is a diversified, closed-end management investment company. The fund invests in loan and debt instruments of issuers that operate in a variety of industries and geographic regions. In general no position is more than 3% of the portfolio and most are less than 0.5%. Van Kampen is one of the older and more experienced sponsors in this space.
Catalyst:
At current price levels, you are basically buying the underlying senior loans at a yield-to-maturity of 30%+. Investors moving up the capital structure to get equity-like returns should cause the underlying loans to trade up. In addition, the equity is a retail product and has been under the technical selling pressure, with substantial net outflows in recent months. Since you are capturing a huge discount through both the depressed NAV (i.e., the loan pricing) and the technical selling pressure on the equity, we expect both to compress in 2009.
Thesis:
During the past year leveraged loans have come under tremendous selling pressure. In the past 3 months the S&P Loan Index has declined over 20%. Historically, the buyers of these loans were structured vehicles known as Collateralized Loan Obligation (CLO’s) or hedge funds that borrowed funds thru total return swaps (TRS) to generate greater returns. As result of the current credit meltdown these hedge funds and CLOs have had margin calls and/or redemptions which created a need to sell these positions at any price irrespective of underlying credit quality. The outflows continue as investors continue to pull their money from these funds during the fourth quarter. This has created a tremendous opportunity for investors who are seeking equity-like returns at the top of the capital structure in securities that have a senior lien on substantially all of the assets of the issuer.
The forced sales of these loans are taking place in the face of underlying credit fundamentals which are solid and even compelling. Many of these forced sales are taking place in the market through “BWIC’s” or Bids Wanted In Competition. BWIC’s are portfolios of loans from CLO’s, trading desks (e.g. Bear Stearns and Lehman) or hedge funds that must be sold and are seeking the best bids from the market in a blind auction. The clearing price for many senior secured debt instruments is below hard asset liquidation value. The potential returns from these instruments equal or exceed historical rates of return on both high yield bonds and equities.
The worst modern period for bank debt was 2001 – 2002 when about 8% of the outstanding issues defaulted. This compares to historical default rates of 3-4% for bank debt and average recoveries (upon default) in the low 80’s. Current spreads on the LCDX Index (which is a synthetic basket of 100 loans) imply a 25% one-year default rate out to the end of 2009. Under this scenario, ¼ of the loans in the index would have to default and receive zero to justify the spreads.
The depressed pricing in the current bank debt market has spread to loans of companies with very attractive business and balance sheets. Because pricing pressures are largely driven by liquidity needs rather than fundamentals, there is little differentiation in the marketplace between solvent and insolvent companies.
As noted in Grant’s Interest Rate Observer (October 31, 2008), “In the day, buyers of these assets thought nothing of borrowing $10 and up for each dollar of equity they controlled. Margin calls have therefore shaken loose great chunks of senior debt. What seemed hugely desirable at 92 cents (for instance) on the dollar when credit was easy, today goes begging in the 60’s and 70’s now that credit is inaccessible. So fractured has the leverage loan market become that some senior bank debt outyields the subordinated debt of the identical borrowing company.” On December 12, 2008, Grant’s noted, “True, such leverage was typically excessive, but the senior secured lenders stand to come out of the experience in a relatively strong position.”
Inception NAV: $19.10
Current NAV: $8.14
Current NAV Discount to Inception NAV: 42.6%
Inception NAV: $19.10
Current Price: $6.64
Price Discount to Inception NAV: 34.8%
Credit Statistics:
Moody’s Credit Rating Distribution
Baa 0.00%
Ba 17.77%
B 40.91%
Caa 11.36%
Ca 0.16%
Not Rated 29.80%
Total 100.0%
Capital Structure Distribution
1st Lien 64.36%
2nd Lien 13.92%
Unsecured 4.97%
Other 16.74%
Total 100.0%
Strengths:
- By buying the VTA you are getting a double discount on a diversified portfolio of senior secured loans. The prices of the loans are well below par and the derivative equity is currently trading at a discount to the NAV.
- On a discount to NAV basis, VTA is trading at an 18.43% discount. At current NAV levels, the assets are marked at 42.6% of the original NAV and the current price assumes a 34.8% mark on the portfolio of loans.
- Diversified portfolio of loans in a variety of industries and regions.
Risks:
- More redemptions and BWICs can put selling pressure on the underlying assets.
- Declining/resetting LIBOR rates my cause the loans to trade down to maintain current yields.
- More defaults than expected.
- Declining distributions due to lower interest rates.
Catalyst
At current price levels, you are basically buying the underlying senior loans at a yield-to-maturity of 30%+. Investors moving up the capital structure to get equity-like returns should cause the underlying loans to trade up. In addition, the equity is a retail product and has been under the technical selling pressure, with substantial net outflows in recent months. Since you are capturing a huge discount through both the depressed NAV (i.e., the loan pricing) and the technical selling pressure on the equity, we expect both to compress in 2009.