• | Priority Income Fund is a SEC-registered closed-end fund that was launched in January 2014 and has raised $450 million of capital. . |
• | We have a 5-year track record of providing our shareholders an annualized dividend of approximately 10%. |
• | There are 5 key features of the fund I would like to highlight: |
1) | Feature #1 is Senior Secured (Slide 3): |
a. | Priority is investing in senior secured loans to large U.S. companies. |
b. | These are the same senior secured loans the floating rate mutual funds from Eaton Vance, Fidelity, Invesco, and Oppenheimer invest in. |
c. | These are loans to large U.S. companies that have a national or international footprint. |
d. | These companies include household names like: American Airlines, Albertsons, Burger King, Dell Computers, and Heinz. When Berkshire Hathaway acquired Heinz, Warren Buffet obtained financing form the senior secured loan market. |
e. | Senior secured loans are the highest priority in the capital structure. |
f. | Loans are first to be repaid before 2nd lien loans, high yield bonds, mezzanine debt, unsecured debt, preferred stock, and common stock, which provides significant downside protection. |
g. | Senior secured loans have a 1st lien on all assets including property, plant, equipment, land, and inventory. |
h. | Senior secured loans have historically experienced a lower default rate than high yield bonds as the average default rate is 2.24% since 2003. |
i. | What happens when a senior secured loan does default? |
j. | Moody's has tracked high yield and senior secured default rates since 1987, over 30 years. |
k. | The historical recovery rate for senior secured loans is 80.4% compared to 47.9% for high yield bonds. This outperformance is due to senior secured loans having priority in the |
2) | Feature #2 is Diversity (Slide 4): |
a. | The fund has exposure to over 2,800 different loans to over 1,000 companies. |
b. | The largest exposure is to Asurion at 0.88%. |
c. | Priority is investing in pools of senior secured loans that require significant diversity. |
i. | Each pool typically has 200 individual senior secured loans. |
ii. | Each loan is limited to 2% of the pool and the average is less than 1%. |
iii. | Maximum industry exposure of 10%. |
d. | These pools are called Collateralized Loan Obligations or CLOs. |
i. | CLOs are not CDOs. |
ii. | CDOs had exposure to subprime mortgages and consumer based debt. |
iii. | CLOs have exposure to 1st lien senior secured loans to large U.S. companies. |
iv. | CLOs are a $600 billion market that has an exceptional track record so not a niche market. |
v. | Of the 1,200 CLOs that have gone full cycle, over 98.1% have provided a positive return to shareholders. There are not too many assets classes that have such a consistent and strong track record. |
3) | Feature #3 is Income (Slide 5): |
a. | The fund provides a 8.0% base dividend with a weekly record date and monthly payment date and a quarterly bonus dividend for a total dividend of approximately 10%. |
b. | At the beginning of September we announced an increase in the base dividend to 8.0% reflecting our confidence in the fund’s ability to continue to pay the dividend. |
c. | How is the fund able to generate 10% current yield? |
d. | CLOs are a spread vehicle where we are generating the spread between the quarterly interest payments the loan pay and the cost of financing similar to a multi-family property. |
i. | Walk through multi-family property example. |
ii. | The assets pay L + 3.75% |
iii. | The financing costs L + 2.00% |
iv. | That leaves you a spread of 1.75%. Since we are getting financing, that 1.75% spread results in mid-teens returns. |
e. | The financing is very-efficient, low-cost, and long-term. |
f. | 65% of the financing is rated AAA, which is the highest rating and therefore low cost. The pool is able to achieve this rating because of the diversification in the pool. |
g. | The financing is long-term at typically 12 years. |
h. | The financing is locked in and cannot be pulled. |
i. | No liquidation events. |
j. | There are no margin calls with the financing as well. |
k. | Financing is non-recourse. We are currently invested in 106 different pools. If for whatever reason 1 pool does not perform well, that does not impact the 105 other pools and there is no recourse back to Priority. |
4) | Feature #4 is Duration or the lack thereof: |
a. | Duration is a big risk in fixed income products as the fed has raised rates over the past 2 years. |
b. | Unlike IG and HY asset classes, we do not have duration risk and Priority Income Fund is not making a bet on interest rates. |
c. | As I just mentioned, we are generating our income through the spread between the interest rate the underlying loans pay and financing we obtain to fund each pool of loans. |
d. | Both the assets and financing are floating rate based off of Libor so our returns are not based on movements in Libor. |
5) | Feature #5 is Access (Slide 6): |
a. | The fund provides access to best in class fixed income managers. |
b. | The pools we invest in are managed by some of the largest fixed income managers in the world. |
c. | There are approximately 150 different managers and we have chosen to work with only about 20 managers that have we consider to have the best track record over the past 10+ years. |
d. | Managers include Credit Suisse Asset Management, Symphony (the credit arm of Nuveen), and Voya. |
e. | But, we have not approved household names like Blackstone / GSO, Prudential, Ares, KKR, Blackrock, Bain/Sankaty, and KKR because of poor track records. |
1. | The fund was launched in January 2014 and it has raised $450M of capital through December 31, 2018. |
2. | As I mentioned previously, we continue to pay a dividend that annualizes to about 10.0%. |
a. | Broken down into a 8% base dividend with weekly record dates and paid monthly. This is an increase from 7.0% we paid for the first 4 ½ years. |
b. | Approximately 2.0% bonus dividend paid quarterly. We have paid the bonus dividend 20 consecutive quarters since we launched the fund. |
3. | The fund has invested in 106 different pools of senior secured loans. |
a. | These pools include over 2,800 individual loans and over $52 billion of senior secured loans representing hyper diversity. |
b. | The fund continues to outperform from a credit standpoint. |
▪ | Priority’s portfolio of $52 billion of senior secured loans had an underlying default rate of 0.46% compared to a market default rate of 1.63%. |
▪ | We have experienced a fraction of the market default rate. |
▪ | We are able to achieve this outperformance by working with only the best in class fixed income managers and utilizing Prospect’s 30-year history of investing credit markets. |
c. | Now, let’s look at the fund’s largest look-through exposures: (Slide 8) |
▪ | Asurion is our largest exposure. |
• | Asurion is not necessarily a household name but I’m guessing over half the people on the webinar are Asurion clients. |
• | Asurion provides insurance plans on personal devices and insures over 305 million personal devices. |
▪ | Dell International: |
• | Large computer company everyone is familiar with. |
• | Dell is now a fully public company with a $33 billion market cap. |
▪ | Altice: large cable company with 5 million customers in 21 states and over $13.5 billion market capitalization. |
▪ | American Airlines |
▪ | CenturyLink is the 3rd largest telecom company in the U.S. behind AT&T and Verizon serving over 27 states. Company has over a $16.0 billion market capitalization. |
▪ | As you can see, these are very large companies |
d. | Now let’s look at the industry exposure in the portfolio. |
▪ | Healthcare is the largest industry right under 10%. We are overweight healthcare due to the aging U.S. population. As people get older, healthcare costs increase so we see favorable trends in this industry. |
▪ | Our next largest industry is technology at 9.6%. This is very large and growing sector that continues to experience strong growth. |
▪ | Energy: We are underweight energy with 2.19% exposure. This compares over 15% in the high yield market. |
▪ | Retail: We are underweight retail with 4.12% exposure. Retail is a very large sector and includes stable companies like Albertsons, the 2nd largest grocery store chain. Our exposure to clothing retailers is less than 1.5%. |
– | The 4th quarter was indeed a volatile period. |
◦ | The S&P 500 was down 13.52% in 4Q including 9.03% in December. |
◦ | The high yield index was down 4.63% in 4Q including 2.19% in December. |
◦ | The senior secured loan index was down 3.45% in 4Q and the index declined from 98.61 to 93.84. |
– | We actually think this market volatility is beneficial to the fund for a couple of reasons: |
◦ | The volatility halted the hundreds of billions of repricings and refinancings the senior secured loan market experienced over the past 2 years leading to a decline in the weighted average spread in our underlying portfolio. |
◦ | Following the volatility we have actually seen an increase in senior secured loan spreads. Last quarter was the first time we saw the weighted average spread in our underlying portfolio increase in over 2 years. |
◦ | Volatility is beneficial to CLOs as it allows the underlying CLOs to purchase loans at discounted prices. Since the financing is locked-in for 12 years and there are no market value triggers, the volatility increases returns and benefits the CLOs. |
– | Despite the market volatility, we continue to think fundamentals remain strong: |
◦ | Year-over-year earnings before interest, taxes, depreciation and amortization ("EBITDA") growth among Senior Secured Loan borrowers remained strong at 13.31% in the 3Q'2018, the strongest growth in 7 years. This is an increase from 12.10% for 2Q'2018 and multiples higher than the U.S GDP growth of 3.5%. |
◦ | The average cash flow coverage, which measures earnings coverage against quarterly interest payments, was 3.5x. 3.5x is the highest on record dating back to 2001. |
◦ | The growth in earnings has also led to the lowest average leverage in over 10 years. |
◦ | Defaults continue to be below the historical average. |
▪ | We expect defaults to remain subdued due to the aforementioned strength of the U.S. economy, strong earnings growth for companies in the senior secured loan market, and a limited amount of maturities. |
▪ | Maturities are one of the biggest driver of defaults. |
▪ | Less than 3% of the senior secured loan market matures prior to the end of 2020 and less than 10% of the market matures prior to the end of 2021. |
– | With the combination of the strong fundamentals and recent volatility, we continue to find investments with attractive risk adjusted returns. |
– | Prospect Capital was founded by senior executives from infrastructure and high yield group in Merrill Lynch in 1988. |
– | We have a 30 year track record of investing in credit markets including over $10 billion in investments made. |
– | John Barry, the CEO of Prospect Capital Management, and Grier Eliasek, the CEO of Priority Income Fund, have worked together for 20 years now. |
– | We have approximately 100 employees including 40 credit professionals that support my team in managing Priority Income Fund. |
◦ | This team is an invaluable resource that we leverage when reviewing the underlying senior secured loans. |
– | We currently manage over $6.0 billion of capital primarily invested in the credit markets. |
– | We were able to take advantage of low spreads in fixed income markets by issuing preferreds at attractive terms that we believe will be accretive for our shareholders. |
– | We initially issued $34 million of preferreds with a 7-year tenor and coupon of 6.375%. |
◦ | The preferreds have zero financial covenants providing significant financial flexibility. |
◦ | The preferreds have a ticker of PRIFA. |
◦ | The preferreds allows the fund to enhance dividend coverage and is one of the factors that led to our increase of the base dividend to 8.0% |
– | Given the attractiveness of the initial preferred, we issued a second preferred stock offering (NYSE: PRIFB) in October 2018 totaling $25 million with a coupon of 6.25%. |
– | The fund is currently levered 0.16x through these preferreds. |
– | There are two main risks I want to highlight for Priority. The first is default risk: |
◦ | Defaults in the senior secured loan market have averaged approximately 2.24%. |
◦ | The market trailing 12-month (“TTM”) default rate as of December 31, 2018 was 1.63%, so we are just below the historical average default rate. |
◦ | Within Priority Income Fund our default rate is 0.46%, so less than 1/3 of the market default rate. |
◦ | Defaults are only half of the story, though, because what you ultimately care about is losses. Because if you remember we are investing in the senior secured part of the capital structure, the recovery rate on senior secured loans when they do default has averaged over 80% over the last 30 years, according to Moody’s, much higher than the average 48% recover rate for unsecured bonds. |
– | The other main risk I want to highlight is the risk of spread compression or reinvestment risk. |
◦ | The portfolio had experienced spread compression for about a 2 year period from 6/30/16 to 6/30/18. As mentioned previously, spread compression has largely abated in the 2H’18 and we actually saw spreads increase for the first time in 2 years. |
◦ | Typically default risk and reinvestment risk do not occur at the same time. I.e. when defaults are high, typically spreads are wide and prices are low, and vice versa. |