Wednesday, March 30, 2011

It’s a dog-eat-dog world and incentives matter

We start by setting a desired target rate of return, and then try to buy the most senior security in the capital structure that meets the return target. We know that in a restructuring, it's a dog-eat-dog world, and senior holders will show no mercy to investors holding lower ranked securities. Experience proves it is prudent to give up some return by buying senior debt versus taking a chance on more junior securities even though they have the potential to earn a much higher return.  

... imagine two scenarios with scenario-one offering the prospect of recovering 50 cents on the dollar for a junior security trading at 25 cents on the dollar, and scenario-two offering the possibility of recovering 100 cents on the dollar for a senior security that is trading at 80 cents and that is backed up by 200 cents of collateral. The wise course, in our view, is to invest in the second scenario and not succumb to the temptation of the first as we believe maximizing the margin of safety on the principal invested is just as important for debt securities as it is for equity securities.

Continue Reading