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Howard Marks Presentation to UCLA Anderson Student Investment FundCapturing Efficiencies in Distressed Debt
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Introduction
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No investments are good or bad intrinsically
It all depends on the timing and the price
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Fashion fads come and go
In 2010, the fad was safety
What Marks does to determine the quality of the investment is to project himself into the future
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What kind of scenario would have to play out for the return to makesense?
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In terms of buying Swedish gov’t bonds at .9% yield, depressionand deflation are the only outcomes that would make thedecision prudent
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Investing successfully surrounds buying assets for less than they areworth
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Distressed debt
What is distressed debt?
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Debt for which the markets do not believe the bonds will pay principleand interest
Generally, distressed debt investors want a creditor claim on the company
Restructuring is the event that comes about after a default
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Trigger (such as restructurings) are important in investing
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3 questions that Oaktree asks itself in determining whether to make an investment
What is the pie worth?
How will it be split up among claimants?
How long will it take?
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If you can get all of these right you can determine the IRR with certainty
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You might want to buy a piece of each of the different classes of debt tohedge the uncertainty of how the pie is going to be split up
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Sub debt for example has nuisance value and its holders canoften extract more than they should when the pie is beingdivided
Oaktree has bought the sub debt even when it believedthe chances of making money were not great in order tohedge against weird outcomes of the pie splitting
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Determinants of supply and demand of bonds
Lowering of credit standards
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These are the logs that provide fuel for the fire
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There is a correlation between the level of issuance of HY bonds and thesubsequent likelihood of default
Onset of economic weakness
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Put a match to the logs and ignites the crisis
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General cycle dynamics
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Build Up
Start off with a hospitable environment
Risk taking is profitable
Credit standards decline as risk aversion declines
Issuance balloons
Quality of issuance declines
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Potential factors that can combine to trigger a crisis
Recession
Credit crunch
War
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Consequences
Prices fall
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Holders engage in panicked selling
Supply overwhelms demand
Price collapse gains momentum
Losses snowball
High prospective returns become available
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Subsequent Events
Economy recovers
Defaults spike
Capital markets reopen
Psychology improves
Prices snap back
Super high returns are realized
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Cycle continues
Default rate recedes
Supply of mainstream debt recedes
Capital for investment swells
Investment opportunities and prospective returns contract
Investors lower their sights and pursue special niches
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First distressed debt cycle Marks lived through was 1980-1993
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People were averse to these bonds in 1980 and1981
The entire universe of high yield (HY) bonds was very small in that time withyearly issuance of only about $1B
Pension funds and endowments did not buy these
Moody’s said B rated bonds were bad ideas in general
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This statement was “crap”
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They ignored price completely
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