DDIC Version 2.0 Announcement

The redesign of the Distressed Debt Investors Club was launched today with many improvements to the user interface and functionality. And we are just getting started. Over the next few months, more and more features will be added to the site to make members' experience better than it has ever been.

One of the requests I seem to get often is a listing of all the ideas that have been written up on the site. From now on, you can access a listing of names / tickers of all ideas ever submitted to the site from the main launch page. Or by clicking this link: All DDIC Ideas Ever Submitted.

It is my goal to close membership applications when we get to 250 members on the site. Members have access to all of the historical ideas on the site (including attachments which guests are unable to see) as well as the DDIC forum where I post 3-4x more frequently than I do on the blog.

A number of the largest hedge funds investing in distressed debt are represented (anonymously of course) on the site. And as the distressed market has effectively dried up, more and more actionable event driven ideas have made their way to the site which I absolutely love.

To those that are concerned with privacy, it is our policy to NEVER reveal personal information about the member or the member's affiliation (whether that be on the buy-side or the sell side). No users, outside of myself, can see personal information of other members except for the ideas that user has written up on the site. I oftentimes get background check service providers asking me if a member (who has placed the DDIC membership on their resume) is in fact a member. I fully ferret out these requests and get the member's consent before revealing even this type of information. In the next few weeks, I will have a letter that you can present to your compliance officer if you have concerns about our practices and disclosures.

For those that have questions or concerns about applying, please email me. The community we have built thus far has been remarkable and I only expect it to get better with time.



Glenview Capital Annual Letter

As always, Glenview Capital, is out with another remarkable annual letter highlighting their diligent investment process and spectacular returns. I have linked to the letter below for your review. In this post, as credit and distressed debt are of the utmost import, I will highlight some takeaways from the letter that revolve around Larry Robbins' discussion of Glenview's participation in the credit markets (with that said, everyone should read the entire letter as it is gold)

  • The firm continues "to withdraw capital from long fixed income strategies and redeploying capital in long equity strategies with superior risk/reward characteristics." Very similar line of thinking that I have employed in the past 6 months. The upside / downside trade in on-the run credit is just not there right now outside of a few sparse situations, whereas in equities, a number of sectors/classifications look attractive
  • Corporate fixed income portfolio winning names: Cengage, MWA, MBIA, TSTR, Fox Acquisition Sub, Local TV and Ceridian. MBIA was such a huge winner for a number of funds last year. The AA CDS year tightened 1200 bps from the peak in June and the AAA CDS tightened nearly 2000 bps from June to year end.
  • Discuss the shape of the treasury curve and how the roll down effects will affect REIT valuations going forward
  • Glenview goes on to discuss how "healthy" the credit markets are by referencing that issuers are marketing holdco PIK toggle bonds inside 11% - frothy = healthy here IMO



High Yield Fund Flows - The correct number...

Earlier today, the headline number for AMG's fund flow for high yield mutual funds was reported at -$2.8 BILLION. Immediately, I knew something was wrong with that number. Despite having a number of high yield and leveraged loan deals (and repricing) been pulled from the market, the market didn't feel THAT bad. My Bloomberg lit up with traders also questioning the number.

With that said, here is what I've heard from the various desks:
  • UBS says there was a calculation issue and hears the consensus HY outflow was 830-850M
  • JPM says they estimate outflow at 830M with the glitch arising from reallocation of funds from liquidated to new/existing fund
  • And I am sure tomorrow morning, all the desks will put out something correcting the headline number
Last week, Goldman Sachs credit strategist Charles Himmelberg, one of my favorites, put out a piece entitled: "Mutual fund flows matter less, but still help track sentiment." I could not put that better. When liquidity is scant in the credit markets, inflows will indeed be very important. But in a market awash in liquidity, effects normalize. According to Goldman Sachs whereas in the wake of the Lehman crisis, $1B of inflows would impact HY returns by 4.5%, today those $1B of inflows would translate into 90 bps of performance.

In my opinion, and maybe I am thinking about this too simply (please correct me if so), fund flows will deteriorate on trailing periods of negative returns for an asset class. The retail investor will inevitably chase returns. And I think after the "Great Recession" they are more than ever chasing "risk-adjusted" returns. Think things like Sharp Ratio here. And compared to alternatives, high yield has done fairly well relative to other asset classes over the recent, and not so recent future.

With that said, unlike equities, high yield bonds have two distinct components of return. Rate and spread. In theory, credit spreads could compress to unheard of tight levels relative to IG or treasuries but that would portend a very robust economic environment which would more than likely be associated with inflationary pressures. Inflations leads to higher rate. And even though the duration of the high yield market is at a historical low and the "date to worst" is the near the shortest of all time, high yield assets will fall if rates increase, especially in the belly / 10 year part of the curve.

If rates rise, flows to credit funds will drop significantly. There is no two ways about it. Market participants will feel that shift before the data is reported. But retail investors will see negative returns because of rate (all else being equal) and pull money from the asset class which feeds on itself until yields hit appropriate levels compensating investors for rate risk.



Harvard Business School Turnaround Conference

Wanted to alert my readers that another OUTSTANDING distressed conference is around the corner. The 13th Annual HBS Turnaround Conference is coming up in a little over a week and looks to be full of great speakers and panelists. The keynotes this year are Harvey Miller and Jeff Aronson who are two of the smartest gentleman in the distressed world these days. And at the price, anyone in the area would be foolish not to go.



Pain? Not so much in the liquid credit markets.

Before I begin, I would like to express my sympathies for all those affected by the terrible natural disasters that have affected Japan in the past week. My prayers go out to all those who have been directly affected or who have friends and family in the area. For those interested in helping, you can donate directly on the Red Cross site here: Japan Earthquake and Pacific Tsunami Relief

How has this pullback in the global equity markets affected the domestic HY markets? Not terribly much as measured by the HY15.

For reference: Here's the post: "Credit markets are in a bubble" Now, to me that chart shows a little bit of pain. Some of the equity and mezzanine tranches have been hit harder, and rightly so:

The above chart is the price of the equity tranche of the HY15. For those not aware, nearly all of the Markit indices are tranched to give investors more places to place their bets. The HY indices are tranched slightly differently than the IG indices:
  • HY has a 0-15% equity tranche, a 15-25% mezzanine tranche, and a 25-35%, and 35-100% tranche
  • IG has 0-3% equity tranche, a 3-7% mezzanine tranche, and a a 7-15% and 15-100% tranche
These percentages are essentially loss buffers protecting the tranche above you. Let's say you are INCREDIBLY bullish on the constituents of the HY15 index and expect no defaults through 2015. Well you would then buy the 0-15% equity tranche at 55 and get par back in 12/20/15. If you were wrong, and there were a number of defaults and low recovery rates, you may get back 0. If depends on the number of defaults and the loss assumptions to figure out what you are going to get back. You can view all these tranches on Bloomberg using the CDOT function.

With that said, yes, there has been some pain in the liquid HY credit markets. Some of the more widely traded names (Charter, CIT, Freescale, Harrah's, HCA, etc) are down a couple of points here and there. But nothing like this:

This is an equity chart of 9501 JP or Tokyo Electric. Obviously that is a unique chart given the nuclear issues going on in Japan, but on the whole, the market that has been hit the most, and consequently, the markets value investors like you and me should be spending our time is Japan.

Yesterday, on the Distressed Debt Investors Club forum, I told readers I was starting to buy a certain Japanese equity. As the day went, and panic increased throughout the day (as measured by the number of Zero Hedge postings and movements in the Yen), I was bought more and more of this one company, taking it to nearly a full position, while nibbling on a number of other companies in Japan.

Some will call me crazy. Some will say I do not have all the facts. It is always uncomfortable to buy things in free fall. Remember RIG during the BP disaster? On the DDIC investor forum I wrote, on June 10, 2010, "I am coming up with a value of $60-$100/share for RIG" when the stock was trading at $45/share and oil was spewing into the Gulf. We know how that turned out.

So for those interested in investing in Japan, here is what I would suggest doing. We are going to do it the Walter Schloss way.
  1. Download all companies in the TOPIX (a capitalization weighted index of all companies listed on the Tokyo Stock exchange)
  2. Remove all companies trading at Price to Book above 1.2x
  3. Remove all companies that do not have an operating history going back 10 years
  4. Remove all companies that have a Debt to Capital above 20%
  5. Start with A...
Some of these companies are MIRACULOUSLY cheap. And in some cases this is rightly so. Japanese companies are notorious for printing ROEs lower than their cost of capital and hence a large portion of the index will trade below book. But, if you take the next few days, and do the exercise above, and pick 5-10 companies and allocate some capital to each of them, I think in a few years you will look back on this experience joyfully.

Inevitably, I will get emails related to this post saying I am crazy myself. That is fine. I may be wrong. I will not always be right. But if I buy WELL capitalized companies, with little to no debt, trading at a large discount to book, with P/Es in the single digits I feel like my downside is protected in the off chance of events worse than what we've seen in the past few days. Remember, value investing is about focusing on the downside. This exercise accomplishes that in an area where there are many questions, and investors are selling irrationally.

And email me any other interesting ones you find. I'm starting back with the A's again tonight.



New Issue "Premium" and its Relation on Secondary Prices

Before I get to the meat of this post, I would like to highlight to readers a very interesting quote from Jeffrey Gundlach, legendary bond investor and founder of DoubleLine Capital, in an interview with Barrons:

"Gundlach's cautious take on high-yield is the result of an aper├žu or intuitive flash he had several weeks ago, that the yield spread between high-yield and government bonds should be calculated using the 20-year government bond, rather than the entire Treasury yield curve. That's because high-yield paper, though maturing sooner than 20-year bonds, shares similar price volatility. The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year bonds is as narrow as it has been at any time in the latest credit cycle, he notes."
While I do not have the data in front of me, this is an interest pronouncement and echoes my feelings that credit markets (high yield/bank debt/distressed [to a lesser extent]) are overvalued. I do not know if it will be next week, or next month, or even 2013, but I believe an investor is not getting compensated for taking risk in the leveraged finance markets. Unfortunately, the primary market, being as wide open as it is allows speculative issuers to extend their maturities out hence lowering the near term expected default rate which is bullish for credit.

According to JPM's Peter Acciavatti: "As such, institutional loan issuance is tracking at an annualized pace of $320bn, versus the previous record of $387bn in 2007 (predominately in 1H). When combined with $62bn of high-yield bond volume YTD, total leveraged credit new-issue volume is tracking at an annualized pace of more than $640bn, versus $457bn in full-year 2010."

That is a lot of credit.

Any issuer would be foolish right now not to aggressively reprice their bank facility or significantly relax (or remove) covenants. And every banker is out there telling CFOs and Treasurers: "If at any point is there a time to do a big M&A / debt financed stock buy back / stuff coffers, now is the time." Private equity is salivating at financing costs, so much so, that a good friend of mine at one of the most respected private equity firms out there said they have to step back from deals because sponsors are getting irrational with multiples justifying cheap leverage.

To the point of the post: Despite the large number of deals across the rating categories, the enormous inflows of capital from the retail and institutional side seem to be dwarfing them where most deals are still widely oversubscribed (this is the case in IG as well, possibly more so). Some deals have not fared as well (JNY 6.875% for instance), but most "better quality deals" have effectively turned into a food fight. And, more so than I can remember in recent pasts, dealers are putting out "whisper talk" substantially wider than where deals are pricing - to the tune of 25-50 bps back from secondary trading levels.

What is happening though, is that these better quality deals are getting priced INSIDE secondary trading levels. This creates a tightening of the entire complex which seems counterintuitive (i.e. more debt leads to more leverage leads to higher default probability). Furthermore, these new tighter prints then become relative value comps for issuers in the same industry tightening up more credit along the line.

As spreads tighten across capital structures and across the industry (for equivalent rated bonds), high yield returns increase. Higher ex-post returns, again counter intuitively, lead to more capital flowing to the space which exacerbates the cycle with primaries printing at even tighter levels.

You would expect that as the syndicate desks tightens up pricing there would be significant amount of "drops" to come to a more reasonable supply / demand balance. The problem is, many investors (I have been guilty of this in the past), have done the work on the issuer and will "suck it up" and take the 25-50bps cut in yield despite the offering not being priced as attractively as before. Further, as a nice chunk of the leveraged finance deal making YTD has been refinancing, funds that want to maintain exposure to certain issuers need to make sure they get their bonds - they will pad their orders creating a situation that many value investors do not like to find themselves in: Irrational / uneconomic buyers. Buying for technical reasons is irrational and will create price movement errors on the upside.

I much prefer buying from irrational/uneconomic sellers that sell a stock because it was kicked out of an index, or because a bond got downgraded to CCC, or a company is filing Chapter 11. In those instances, the "technicals" are working for me, my potential return has increased, and my potential downside has decreased. That is the opposite of the credit markets today. I hate to use the term "bond pickers market" (it sounds ridiculous), and instead will use the term "avoid land mines market" Shorting the credit market in aggregate while selectively playing credit stories you believe in and waiting for uneconomic sellers to arise throughout the year is the prudent way to navigate this market. For those interested, and I will do a post on this at some point, I think buying protection on certain tranches of either HY CDX tranches (or the vanilla HY15 index itself) or certain tranches of the IG15, which is much cheaper, and has greater skew (cost versus upside) makes sense, especially for those interested in tail hedges.



European Distressed Debt Market

Today, Bloomberg posted an article on Oaktree Capital's intent to purchased distressed debt investments in the EU as opportunities for distressed debt in the United States are slim to nil"

"March 3 (Bloomberg) -- Oaktree Capital Management LLC, an $82 billion investment firm, plans to purchase more distressed assets in Europe as a price rally eroded the return outlook for U.S. corporate debt, according to Chairman Howard Marks.

'The better opportunities lie in Europe because banks have some purification job to do on their portfolios, and in mid-cap deals and also in debt related to commercial real estate,' Marks said in an interview in Berlin yesterday. 'We indicated to our investors in 2008 that a return before fees of more than 25 percent is possible. Today, you can’t get that level of returns from traditional U.S. distressed debt.'"
As I have done in the past, I will layout a graph of the number of traced distressed issuers traded over the past year:

As one can see, the index has effectively grinded tighter on the whole since QE2 was hinted by Ben Bernake in the late summer of 2010.

In past cycles, distressed debt returns have held up a few years after default spike. But looking back in history, one can see that not only has annualized returns dropped, but the length of the "comeback" if you will has gotten shorter. For example, distressed produced fantastic results over 6 years in the period following the 90/91' recession (through 97'). In 2003, distressed had a fantastic year as well, and was followed by strong returns in the following 3 years. That being said, these returns were no were near the length or the magnitude of the previous cycle. Why is this?

In my estimation, there is simply a whole lot of capital in the distressed debt world. Bonds may not fall far enough and are snapped back at a precariously fast rate. And admittedly, we should have had more defaults in the 2008/2009 period, but massive fiscal and monetary stimulus turned off that spigot quickly. Of course, some players, like Oaktree, made absolute bank from the cycle: The fund that Howard Marks began marketing in 2007/2008, returned 31% gross to investors - and they are returning the capital because a lack of opportunities.

Now, to get back to the original point of this post, Howard Marks thinks the European distressed debt market offers a better opportunity set than the US. While my mandate professionally does not allow me to invest in non-dollar denominated assets, the potential risk/reward does look better than the distressed market domestically. Here are some things to consider:
  1. Research analysts estimate that banks in the EU will have to shed more assets than US banks: Typically, and as played out by this cycle, public distressed securities rally over the course of a few years then banks and other financial institutions begin to shed assets that will probably sell at a more reasonable valuation. Banks can get away with this because historically they marked to model and did not have to take capital charges for unrealized losses on the balance sheet. Domestically, banks will begin to sell off their CRE loan portfolio (and equity positions) - This morning Sam Zell noted, regarding CRE: "...because of zero interest rates, there is an awful lot of assets that in another arena would have already been REO. And so the result is, there is very little supply. The banks are feeding their distressed assets into the market very slowly, so the supply of new stuff is low." But then Zell went on to say that capital domestically is sky high and that prices probably will not drop to make real juicy returns (here's the video: http://www.cnbc.com/id/15840232?video=3000008432&play=1). In Europe though, banks are under significantly more pressure due to a variety of issues (cross ownership of sovereign bonds for instance). Net / Net more "forced" sellers in Europe, especially considering Basel III implementation
  2. The amount of capital chasing distressed debt in Europe is less than that in the United States: I do not have figured in front of me, so you will have to take my word for it. The list of dedicated distressed debt funds in Europe numbers about 40, whereas in the United States its a little less than 300.
  3. Complexity. In the EU, bankruptcy leads itself more to liquidation than restructuring. Furthermore, while cross-nation rehabilitation rules have been somewhat standardized, the fact remains that many of these rules have not been tested in an actual restructuring proceeding. In my opinion, complexity leads to more opportunity
When looking at dealer runs for European distressed debt I am greeted by a list of opportunities I have never heard of. In the coming weeks, I am going to try to find 2-3 managers playing in the distressed space in Europe and conduct an interview with them (if you know of any, please contact me). To me, when the competition is less, and their are more forced sellers, good things are bound to happen for your investors.

I will do my best in the coming months to add to my coverage of the EU distressed debt market - if you would like to help, contact me at hunter [at] distressed-debt-investing.com



hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.