Wednesday, February 10, 2016

Howard Marks comments...

Some comments from Howard Marks during Oaktree Capital Group's call yesterday:

Howard S. Marks

As you know, 2015 was generally challenging for the credit markets. The carnage in commodities, coupled with macroeconomic concerns about possible slowing growth worldwide, particularly in China, led to broad market volatility which emerged at the end of the second quarter and persisted through year-end. Further fueling this fire, banks trading capital is at a low ebb. With more restricted regulatory policies, the banks are increasingly unwilling to make markets.

With this as the backdrop, riskier assets such as high yield bonds were particularly impacted. Reflecting levels of risk aversion not seen since the financial crisis, the average U.S. High Yield Bond plunged 10 points in the second half to a price of 87, its lowest level since June '09.

All told, the asset class lost a substantial 8% in the second half, making 2015 the third worst year in our more than 30 years of involvement with high-yield bonds. 12-month performance across all of Oaktree's high-yield strategies was strong in relative terms, with all of them, that's U.S., European, expanded and global, beating their primary benchmarks. Our skill in credit selection and an underweight position in energy gave us our superior relative outperformance.

For U.S. High Yield Bonds, however, that still translated into a loss of about 4% for the year. The start of 2016 marked the 30th anniversary of the beginning of the excellent management of this area by Sheldon Stone and the team he's built. Their outperformance in down-markets has given rise to a since inception gross return that has beaten the benchmark by more than 100 basis points a year for 30 years. That edge compounds into a lot of additional money for Oaktree's long-term clients.

Further, our expertise in high yield bonds contributes to enhanced expertise across the whole credit spectrum. We expect a meaningful uptick in U.S. High Yield Bond default rates over the next 12 months, with distressed energy sector contributing more significantly. As I believe you know, over the last 5 years the average default rate has been just about the lowest in history for such a period.

Now supporting the expectation that defaults will increase is the sharp increase over the past year in the fraction of U.S. High Yield Bond universe trading at or below 70% of par. This stressed cohort grew to 15% at the end of 2015. Additionally, billions of dollars in investment-grade energy and metals and mining debt could be downgraded to high-yield status if commodity prices remain depressed.

With the record amount of dry powder and our ability to add value and distressed assets across multiple strategies, including control investing, real estate, strategic credit and, of course, most prominently the Opps Funds, we are more optimistic about the ability to find attractive investments than we have been for several years. Risk aversion is back after a 5-year hiatus, and a burgeoning supply of distressed opportunities is on the horizon. What started as a largely oil-and-gas-focused dislocation has generalized into weakness across nearly every commodity subsegment. And weakness is starting to bleed into other segments of the bond market, including media and retail. While more interesting debt opportunities are on our plate now than at any point in the last 5 years, we plan to be patient and wait for a pickup in default rates before becoming materially more aggressive in investing our capital.

As Bruce said in the last quarter's call, we have been patient in deploying Opps Xa's capital as we expect better bargains down the road with lower-priced, higher-prospective return distressed debt opportunities. One area we are selectively adding to at the present, however, is Europe. The reasons for our optimism about Europe include Europe's evolving economy and the ECB's quantitative easing, which is supporting credit fundamentals. It's also worth reemphasizing Europe's lower exposure to known troubled sectors, such as commodities, and its structurally lower sensitivity to interest rate movements.

Turning to the opportunity in our distressed power funds, we are hopeful that the sustained decline in commodity prices and the recent turmoil in the energy and public markets will lead to lower-value Asian expectations on the part of owners of companies we'd like to acquire. In many cases, relatively indiscriminate market dynamics are affecting the perceived value of companies in the sector, even businesses that are not highly correlated with commodity prices. We currently have a very robust pipeline of potential acquisition opportunities, and our deal funnel is about as strong as it has been in some time.

The bottom line is that this is a good time to have capital to spend. Back 21 months ago, May 2014, Bruce and I and the Opportunities Fund team sat around and talked about sizing Fund X. And we made the decision at that time to target about $10 billion for the sum of Xa and Xb. And this was based on our belief that the capital markets had been overly generous and indiscriminate in the preceding 3 or 4 years and that the economic recovery was both very modest and long in the tooth and that -- especially that it would be long in the tooth by the time we got around to investing Xb. We do these things kind of on instinct and judgment and gut feel and hunch. And the reasons are not always documentable at the time. But I can tell you that we're feeling very good at this point about our decision almost 2 years ago to raise a very substantial Xb fund in reserve. And of course, this is something we've been doing for almost 30 years now in the distressed debt funds, and these gut decisions have been surprisingly beneficial.

So it's impossible to know with certainty what lies ahead. And that's why our investment approach emphasizes risk control and selectivity rather than market timing. And we try to size the funds right, but we don't feel that market timing is going to give us our edge.

In the short and long run, we continue to believe that avoiding the losers will allow the winners to take care of themselves, as it always has in Oaktree's history.

I've often said that it's difficult to be able to accomplish all 3 key aspects of our business at the same time: raising capital, investing it wisely and harvesting it profitably. We are rarely able to make great buys and great sells simultaneously, and it would be naive to expect otherwise. It's also rarely the case that you can raise capital from your worried investors at the very same time as you have opportunities to invest in a plummeting market; the 2 rarely go together.

2015 was a strong period for raising assets, and we believe we're very well positioned to begin a period of more aggressive deployment. There's a better chance than we've had for years that opportunities will invest -- to invest profitability and then harvest will follow in the desired order.


Patrick Davitt

To your comments around maybe still waiting a little bit to get very aggressive, particularly in the Opps funds, could you give us a little bit of an idea of any kind of broad indicators you look at to suggest that either credit has corrected too far in certain places or has further to go? And in that vein, how do you balance your very, very long history of investing in credit/wealth with the very, very different liquidity environment that it feels like we're in now relative to pretty much any other time given kind of the pullback in the banks?

Howard S. Marks

Well, thanks for that question, Patrick. I think that there is no one quantitative thing that we follow to tell us how to behave. As I indicated in what I said before, it's really judgmental. We just want to have a feeling as to whether -- how bad we think things are going to get and the extent to which the coming problems are incorporated in prices. Now most of the work we do is bottom-up rather than top-down. So we make our decisions based on individual cases, how -- what do we think it's worth and how cheap do we think it is now. And I think we'll always continue to do that. Now we do like to bring our experience to bear and say that this kind of feels like that period or that period and think about how they worked out. Now one thing to take note off is that the average spread on high-yield bonds passed the threshold of 800 basis points. And we've been having a lot of discussion about that around here. Historically, on average, when you bought high-yield bonds when they pass that 800 bps threshold, you did extremely well over the coming 1 and 3 years -- yes -- and especially well relative to treasuries. Now having said that, however, most of the time when high yield bonds exceeded 800 they went on to exceed 900 and 1,000 and 1,100. So -- and that's really what we struggle with. And I have to tell you, Patrick, that this is never an easy decision. And I have the most vivid memory back in the fourth quarter of '08 after the bankruptcy of Lehman Brothers. Of course, I was meeting with Bruce several times a day. He had $11 billion in Fund VIIb that he was trying to decide whether to invest and how fast. And I got to tell you, one day he would say, "I think we're going too slow." And the next day, he'd say, "I think we're going too fast." And the next day, he'd say, "I'm going too slow." So I figured, well, we must be doing it about right. As I indicated in one of my recent memos, we never feel that great about these decisions when we make them. They're hard decisions. And you have to make it without any real concrete milestone. And the only thing I can take comfort with is looking back all those uncomfortable decisions have pretty much worked out.

Patrick Davitt

Okay. That's all very helpful. And how do you balance all of that historical knowledge with what feels like a very, very new type of liquidity environment than we've ever really seen?

Howard S. Marks

Well, it's always something's different. But that's why Twain said history does not repeat but it rhymes. The great thing, especially for the distressed debt business, but for most of our business as you look across Oaktree, is that our returns don't come from Mr. Market. And particularly in distressed, typically we buy the debt; we go through a restructuring process; the restructuring process kind of crystalizes the value and unlocks it. And after holding for a few years, we tend to start selling when it approaches what we consider full value and then scale out. But I have to say that we enjoy an enormous luxury that in our -- in the strategies where we own the most liquid assets, we have the most lock-up. And I shudder at the thought of trying to invest in these asset classes without locked-up money. And you just couldn't possibly do the right thing. So we are -- if we invest Opps Xb, and if we start sometime in '17 or in the early '18, and I don't need to say I know when it's going to be, that means that, that fund has until 2025, '26, '27 for their investments to work out. And I fully believe that sometime in that time span, as Ben Graham said, the market will convert from a voting machine to a weighing machine; and sometime in that period, we'll get full value if we bought the right things.


Michael J. Cyprys

So first, just a question for Howard. With high-yield spreads today certainly, well over 70, 100 basis points, at levels typically associated with recession, but then we see U.S. housing seems strong, improving jobs are strong, corporate balance sheet in good shape. Yes, energy is under stress. But I guess, just how do you think -- but do you think that credit markets and commodities could shake enough that causes corporates broadly to cut back on hiring and CapEx and overall kill [indiscernible] and possibly bring the U.S. into a recession? How are you thinking about this year?

Howard S. Marks

Well, first of all, Michael, we fired our economist. So -- actually that's not true. We never had one. But we really don't take a position on questions like that. My general feeling is, and I think I expressed this in -- on the couch, I just don't think that we're in for a recession this year. And my feeling is that we've been limping along for several years now with an anemic recovery and even seems to be losing energy from that low level. But having said that, the consumption side is pretty good. I think that the gas savings are allowing people to improve their financial pictures. And the services businesses are resilient. Of course, we're not highly dependent on China for purchases of our exports. So -- and again, the last thing I want to do is present myself as an economist. But I just don't think that there's going to be a recession starting this year. Eventually, we're going to have a recession. We always do. But I just don't think it's imminent, and I don't think it's going to be a strong one, in large part because we didn't have a strong boom. We didn't have an overexpansion of facilities or of payrolls. And so I just -- I think it's -- people are so down on everything now, because -- largely because of the market performance, but I just don't share it.