Thursday, February 7, 2019

Howard Marks on the current environment

Here are some comments from Howard Marks on the Oaktree Capital Group earnings call from a couple of days ago that I thought were worth highlighting:
So where do we stand today? I see the fourth quarter price action as a dash of cold water that cooled off some unwarranted enthusiasm. All of a sudden, credit spreads widened, and it was hard to raise money or refinance debt. I take these as signs of helpful prudence. That said, those losses now have been recovered to a large degree, so I'd say investors were chastened but back to being optimistic, especially with developments with the Fed and trade with China now perceived as positive. 
I continue to believe that asset prices are relatively high, and as the fourth quarter proved, investor psychology is fragile. As we begin 2019, the outlook for defaults in corporate credit remains quite benign, with strategists projecting high yield bond and leveraged loan defaults about 1.5%, well below the long-term averages in the areas of 3%. Thus, a supply of U.S. distressed, tradeable investment opportunities may continue to be modest. We saw in the fourth quarter the ability of our teams to deploy capital into some high-quality traded credit opportunities in weak times. As 2019 has started off with a relief rally, the focus of the distressed debt teams active pipeline has reverted to private deals in Europe and Asia and attractive opportunities in sectors such as telecom, healthcare and retail. 
Now is a good time to have dry powder, and we do, given the outstanding amounts of low-quality debt and fallen angel candidates, BB debt that could be downgraded. They are significantly greater than they were prior to past times of expanded opportunity. 
On the one hand, the issuance of low-grade debt has been very strong, plus the issuance of BBBs, which has the potential to become low-rated, and the -- it may or may not be synonymous, but the standards for credit issuance has been very loose. I put out a memo on September 26 entitled "The Seven Worst Words in the World," Too Much Money Chasing Too Few Deals. The consequence of that condition is always a weakening in the strength of deals, in addition to an increase in the pricing, so more issuance, lower quality and, obviously, some fragility in investor attitudes. Some things did get cheap in the fourth quarter, and we were able to put $4 billion to work, which I think is a good plus. Not merely the existence of the opportunities, but the fact that despite the crumbling -- seemingly  crumbling environment around us, our people were able to gut it out and put money to work. And that's what we should do, but it's always nice to see it happen.  
On the other hand, as you indicate, part of the weakening of deal structures over the last several years has been the disappearance of covenants. And when there are no covenants, it means everything else being equal that any distress that does arise, defaults, I should say, that does arise, tends to happen later. It can't happen for technical reasons, breach of covenant, and it can only happen for money reasons. So all things being equal, the defaults will come later than they otherwise would have. But they'll probably be worse because by the time companies default having been able to go on for -- and do business for a long time in breach of covenants, they would tend to dissipate more of their assets. So the rating agencies, for example, have estimated that recoveries will be considerably less from this round of financing than at the historic levels. So many crosscurrents.  
I think that I would sum up by saying that the stage has been set through what we call around here the unwise extension of credit and in particular, the heavy reliance on adjusted EBITDA for an elevated -- for our fourth occasion of elevated opportunities. We had great opportunities in the funds that were formed in 1991, '01/'02, '06/'07, great opportunities. And we think that the pieces are in place for the fourth such opportunity, but we need an igniter. And that will probably require a recession because, especially given the absence of covenants, you're unlikely to get much of a pickup in defaults and, thus, in opportunities for us until you get a recession. 
And I'll throw in that in the fourth quarter, in December, when things were cascading down, I was starting to salivate. I mean, we were seeing debt prices plummet, spreads widen out very substantially by a couple hundred basis points, total inability to issue a high yield bond in December for the first time in many years. We had a month without any issuance. So at that moment, we were optimistic both as to the timing and the size of Opps XI and, of course, with the recovery. We're a counter-indicator, so with the recovery, now we're less optimistic. But these things will change a lot between now and then. 
I'd love to say we're smarter. But most of it is that our approach to investing emphasizes good participation in benchmark returns when they're good and protection against declines when there are declines. And so we really get to show our stuff in tough quarters, and I think we did, as a result. I think that's most of it. There's nothing specific. For many years, we've been fully invested but cautiously. And the fourth quarter was a period when it paid off extremely well, and there haven't been many such periods. But I'm proud of having remained fully invested. That's really the key.  
Our caution has permitted us the confidence to remain fully invested over this period. And that means that we have participated in most or all or sometimes even more than the benchmark returns. And then, when the stuff hits the fan to outperform on the way down, that's really our ideal.