Having Fun Yet...Part III

In early August, I wrote: "It still feels like to me that high yield credit just hasn't felt near the pain of equities on the aggregate or on a single name basis." I can confidently say that that pain is now being felt in the high yield market.

Whether it be the story about credit funds that had a currency overlay selling to meet redemptions on a ridiculous Brazilian Real move, or the fact that dealers are carrying VERY low inventory right now and the market is very illiquid, or maybe the research piece from Moody's citing certain credits with significant refinancing risk through 2015, or the opinion that the entire world is repricing risk - this market feels night and day versus early August.

One of the best buy-siders I know told me a few weeks ago that the head of his fund organized the entire investment team and said: "There are easier markets to make money in." Whitney Tilson, of T2 Partners, stated in his most recent email that they are "hearing a large number of hedge funds are going to cash, unable to figure out this market and trying to avoid further loss."

This market is clearly treacherous. You hear the term "being pretzeled" thrown around frequently. Just look at the S&P 20 day intraday chart, capped off by today's out of no-where really to finish the today hugely positive:

Pretzeling is effectively getting short and long at the most inopportune times. Right when the market is crashing, and you put on shorts to protect yourself, you get whipsawed by a ferocious rally. I also like the term "getting your face ripped off."

Most certainly, the macro environment (Europe specifically) is the tail wagging the dog as it were. The Reformed Broker put up notes from a speech Jeff Gundlach gave at the New York Yacht Club. Regarding Europe:

"I don't know what's going to happen in Europe but there is one thing I am certain about - eventually, someone is going to take a big loss. As investors, the most important thing we can do is to make sure that we aren't the parties taking that loss."

I do know, that watching the crisis unfold in Europe is like pulling a bandage off at a snail like pace. It's frustrating to say the least. The last thing the market likes is uncertainty - and I, in my career as an investor, have probably never seen a situation that was both so uncertain and had such a large ramification on investor risk appetites globally.

Moving back to high yield, today on CNBC, Jeff Gundlach had this to say (you can see the entire video here Jeff Gundlach on CNBC):

"We are getting to where it is not easy anymore. We talked about 6 months ago - it was so easy to avoid this junky credit. I remember in March and April, we were talking high yield bonds and CMBX was the most overvalued in history and it was easy to avoid. Now, it has dropped so much, the way we look at it at Doubleline, from a valuation perspective, junk bonds are actually cheap now...

Now is the tough part, because the valuation is there, but the technicals and the momentum are terrible. And because of that, it is too early to buy. It is now very difficult because the valuation side of it is supportive of the market.

But I think that this thing is going to get a little bit cheaper, particularly as we move forward and we rethinking the earning and default situation, which won't be an imminent turnaround, but when you think about late 2012 or 2013, you are going to be facing higher default rates. And its just not that likely that you are going to get a sustained rally in credit, when defaults are about to move to the upside. It's too early to buy, but the valuation is okay. It's a lot trickier now."

Like the shipping industry pieces I was reading a few weeks ago, the general sentiment is that while the market is cheap, the next move is lower. If you read strategy pieces across street, you hear that general sort of theme. This is what Peter Acciavatti said in his most recently high yield strategy piece:

"On the one hand, high-yield bonds and loans look cheap on a relative value basis, effectively already pricing in a high chance of a recession—current high yield bond spreads estimate a 60% chance of recession versus our economists placing the odds at 40%—while implied default rates for bonds and loans based on today’s spread levels are 8.5% and 16.7%, respectively, versus our belief that default rates, in the event of a recession, would only rise to 5-6%. On the other hand, regardless of any perceived value, both markets remain vulnerable to further selling pressure in the near-term while broader market volatility and uncertainty remain extremely high."

Yet, then he goes on to say:

If we extend our focus to longer holding periods of one to five years, high yield if purchased from a spread base of 800bp has historically performed quite well. For example, high-yield bonds have provided average annualized returns on a one, two, three, four, and five-year basis of 10%, 14%, 14%, 13%, and 12%, respectively. During the 1-year horizon returns were positive in all 6 examples, albeit with nearly flat returns in the 12-months following the October 2000 and June 2001 examples, a result of a market enduring fits and starts amidst the 9/11 terrorist attacks and corporate fraud situations in 2000 and 2001. Notably, if you had invested in high yield bonds in September 2008 as spreads were first crossing 800bp, you would have endured spreads widening to a record high 1900bp during the next 12 months and still managed to record a +5.7% return."

I will be the first to tell you that it will be hard to replicate those two, three, four and five year average return numbers simply because the curve is so tight and (I have been saying this for a 6 months now) is business fundamentals improve, in theory the treasury curve will widen causing a headwind for long term total return numbers. And on the flip side, I do not see a massive forced seller of credit / distressed credit that we saw coming from Lehman's prop book in 2008, so spreads probably don't widen to post-Lehman levels.

Nonetheless, it is hard for an investor that must report monthly returns to investors to be anything but myopic.

Here is my favorite chart on the current sentiment of the high yield / distressed market:

This is a chart of the number of distressed issuers traded on Trace (a distressed issuer is defined as a company with a bond trading 1000 off the benchmark treasury). The chart is probably worse than this because a number of bonds are being quoted way too high. Nonetheless, relative to the same chart just 6 weeks ago, you can see sentiment is getting worse and assets are getting cheaper. What has astounded me is the number of news stories about restructurings / distressed exchanges hitting the tape: AMR, HOV, GMR, EK, etc. A distressed investor has A LOT to do these days.

What am I doing? As usual, up in the capital structure, with large margins of safety. I even bought my first primary secured bank deal in some time in the past week. I've bought some over-collateralized EETC at low double digit deals recently, some stressed pieces of first lien bank debt, and a few DIPs that I never got fully allocated on. I'd expect the average return on those assets to be in the 10% range with little downside risk - acceptable in the face of what Jeff Gundlach was referencing above (i.e. higher defaults coming down the pipeline).

If a full allocation was a strong nine-inning game, I'm probably just finishing the third inning in terms of allocating capital. In terms of unsecured pieces of paper / equities, I've bought one bond that has gotten unfairly walloped due to its exposure to China, and bought one or two high quality equities, and a few insurance stocks, where I think a recession and low rate environment, respectively, are more than priced in. My largest PA investment, well known on the Distressed Debt Investors Club, is a liquidation play where the deal is closed, and my recovery will be higher than today's stock price - I'm just waiting for the cash now.

The pendulum has swung to a real level of anxiety in the market. I wouldn't say all out fear yet and think a failure or three of large European institutions (triggered by a surprise Greek default perhaps) would be the tipping point as it were. Though a Euro-bond is just as likely: markets rally hard on that news, and risk taking is back on the table. Even with that though, defaults in the high yield market is increase precipitously over the next 36 months, and the astute investor who understand the landscape, should be able to make better risk adjusted returns than today. Still though, there are, in my humble opinion, investments TODAY, that will provide you both a return of capital and a sufficient return on that capital, with large margins of safety. Just have to dig to find them.