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Tuesday August 03 2021
About Special Situations Fixed Income
  Articles by Dion Friedland
  Protection Against An Aging Bull
  Reducing Market Risk with Merger Arbitrage
  Interview with Dion Friedland
  Taking the Mystery Out of Hedge Funds
  About Special Situations Fixed Income
  The Kingdom of Hedge Funds
  Distressed Securities Investing
  The Case for Convertibles
  Private-to-Public Investing
  Global Macro Investing
  Market Neutral Long/Short Equity Trading

by Dion Friedland, Chairman, Magnum Funds

In today’s volatile investment climate, where market downswings of late have been as high as 10 percent in a single day, many investors are looking to bonds for the stability of fixed-income returns. The problem is, most dollar-denominated, credit-worthy bonds pay interest of little more than 7 percent a year. If you seek higher, double-digit yields, typically you’re looking at junk bonds which may carry greater risk of default. Junk bonds are bonds with a credit rating of BB or lower issued by companies without long track records of sales and earnings, or by those with questionable credit strength.

An alternative for investors looking for higher returns without dependence on equity investments, which tend to be volatile, is to invest in the fixed-income securities of "special situations" companies. Special situations companies are ones that have undergone some kind of event or situation that has caused them to be misunderstood by Wall Street. These may be companies with complicated pay-out structures or uncertain cash-flow reimbursement streams. They may be new issues or spin-offs not yet followed by the investment community, or companies in industries experiencing negative publicity causing them to fall out-of-favor with Wall Street. Such companies often offer bonds with high yields not necessarily because they are a poor credit risk but rather because the facts surrounding these companies may be obscure or difficult to understand without detailed research. The more complex the situation, the more misunderstood it is, resulting in lower purchase valuations and potentially larger rewards for those able to correctly interpret the information.

Take a company like USN Communications. Started in 1994 with the intent of being a competitive telephone access provider, the company changed course in 1996 due to the high cost of developing switching facilities and decided to become strictly a reseller. When it sought financing in August of this year, it still had negative cash flow; furthermore, with Wall Street mixed about telecommunications resellers as a group, questioning whether they could make money on small spreads, USN had to resort to high-yield, 14 5/8 percent bonds, coupled with options to purchase 11.1 percent of the common stock, in order to entice investors. This despite the fact that USN had $125 million in equity from major investors like Merrill Lynch Asset Management, Chase Venture Capital, and Bankers Trust, along with comprehensive agreements with major telephone providers such as Ameritech and MCI to resell local and long distance service – hardly the credentials of a junk bond issuer.

Or consider Iridium LLC, a company developing a global telecommunications infrastructure highlighted by the launching of 66 commercial satellites. As it was a young company, Iridium was not followed by analysts from major Wall Street firms, and when it sought financing for its multi-billion-dollar effort to provide state-of-the-art telephonic paging and email capability to businessmen throughout the globe, it issued 13 percent senior bonds along with warrants giving investors the option to purchase five shares at $20 per share for every $1,000 bond. These attractive yields were offered despite the solid underpinning of an equity partnership with a worldwide consortium of leading industrial companies such as Sprint and Motorola.

If Wall Street fails to recognize companies like USN and Iridium, at least in the stages of their bond issues, it’s because such companies – or, rather, their compelling stories -- are not easy to identify. The stories behind young companies, or spin-offs, or companies with complicated restructurings or companies in out-of-favor industries are often too complex, or at times too obscure, to uncover. Smaller institutions lack the resources to weed through these stories, and larger institutions, not seeing a big enough pot at the end of the rainbow or not perceiving that these companies are likely to become investment banking clients, often decide against deploying their resources for the required detailed research. The result can be overlooked high-quality companies offering under-priced, high-yield bonds.

How does one learn of these companies? One fund manager who dedicates a fund specifically to special situations, fixed-income investments is Ernest "Doc" Werlin, manager of the High View Special Situations Fixed Income Fund. Werlin’s fund has a joint venture with Horizon Asset Management, the largest independent investment research firm in the United States, to assist in identifying these investment opportunities.

It seeks to profit from the interest paid on these companies’ bonds, plus any appreciation in the bond prices or the prices of discounted equity positions attached to bond issues such as warrants -- the right to buy a certain number of shares at a fixed price for a specified period of years – or convertible bonds, which are options to convert bonds to equity if the future value of the stock holdings are worth more than the bonds. Some of Werlin’s other special-situations, fixed-income strategies include making direct loans to companies at double-digit interest rates (provided the borrowing companies also offer equity options or warrants in exchange for the loan), purchasing high-yield bank loans that banks want to get off their books at a discount, and providing bridge loans to companies prior to an initial public offering – again, provided equity incentives are offered.

"Special-situations, fixed-income investing provides a unique opportunity for investors to achieve steady returns with little market correlation," Werlin explains. "Even in down markets, investors profit from the bond’s interest payments, and the fact that we invest in bonds with short time horizons means that even if bond prices drop, investors get back their full investment -- plus the earned interest -- after a relatively brief period of time."

Of course, the added bonus expected in special situations fixed-income investing is that bond prices – as well as the prices of equities -- will rise once Wall Street catches on to the mispricing that has occurred by a company being under-researched, out-of-favor, or misunderstood. The reasoning is that the more a special situations investment is overlooked, the greater the gap between its current price and the price that should eventually result from the recognition of the intrinsic value. Once the investment community recognizes this gap, a company is re-rated, causing its bond yield to drop and the bond price to go up. Furthermore, as such investments are usually driven by events specific to a company or industry, they tend not to be correlated to overall market trends.

Consider the case of Saberliner, Inc., whose bonds collapsed upon news that the company’s subsidiary had improperly prepared the canisters that caused the ValuJet plane crash in Florida. Those like Werlin who closely analyzed the situation saw that claims against the subsidiary wouldn’t impact the parent because of sufficient insurance and limited liability. When the market awoke to this reality, Saberliner’s bonds, which had been marked down based on the market’s incorrect assessment of the situation, surged in price (as did High View’s investment).

This, however, as mentioned, is only the added bonus. The primary attraction of fixed-income, special-situations investing for today’s cautious investor is its consistent returns without undue dependency on an increasingly volatile stock market.

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