Howard Marks’ Memo: Too Much Money Chasing Too Few Deals

  • In investing, the opportunity to buy an asset or make a loan goes to the person who’s willing to pay the highest price, and that means accepting the lowest expected return and shouldering the most risk
  • In 2005-06, Oaktree adopted a highly defensive posture. We sold lots of assets; liquidated larger distressed debt funds and replaced them with smaller ones; avoided the high yield bonds of the most highly levered LBOs; and generally raised standards for the investments we would make
  • What caused us to turn so negative on the environment? The economy was doing quite well. Stocks weren’t particularly overpriced. We had no idea that sub-prime mortgages and MBS would go bad in huge numbers
    • Rather the reason was simple: with the Fed having cut interest rates in order to prevent problems, investors were too eager to deploy capital in risky but hopefully higher-returning assets
    • Imprudent deals that were getting done in 2005-06 were reason enough for us to increase our caution
  • What are the elements that have created the current investment environment?
    • World’s central banks flooded their economies with liquidity and made credit available at artificially low interest rates
    • Yields on investments at the safer end of the risk/return continuum to range from historically low in the US to negative in Europe
    • By injecting massive liquidity into the economy and lowering interest rates, the Fed limited the losses and forced the credit window back open
    • Combination of the need for return and the willingness to bear risk caused large amounts of capital to flow to the smaller niche markets for risk assets offering the possibility of high returns in a low-return world (higher prices, lower prospective returns, weaker security structures and increased risk)
  • Implications of the duration of the current cycle:
    • Enough time has passed from the trauma of the crisis to have worn off; memories of those terrible times to have grown dim; and the reasons for stringent credit standards to have receded into the past
    • It’s worth noting that nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly. Thus newly minted investment managers haven’t had a chance to learn firsthand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital
  • Debt levels:
    • Between 2007 and 2017, the ratio of global debt to GDP jumped from 179% to 217%
    • Proportion of global highly-leveraged companies – those with a debt-to-earnings ratio of 5x or greater – hitting 37% in 2017 compared with 32% in 2007
    • Debt of US non-financial corporations as a percent of GDP has returned to its Crisis level and is near a post-World War II high
    • Total leveraged debt outstanding is now $2.5 trillion, exactly double the amount in 2007. Leveraged loans have risen from $500 billion in 2008 to almost $1.1 trillion today
    • Amount of high yield bonds outstanding is roughly unchanged from the end of 2013 but leveraged loans are up $400 billion. These trends are due to strong demand from new CLOs and other investors seeking floating-rate returns
    • Some $104.6bn of new leveraged loans were made in May, topping a previous record of $91.4bn set in January 2017, and the pre-crisis high of $81.8bn in November 2007
    • BBB-rated bonds now stand at $1.4 trillion in the US and constitute the largest component of the investment grade universe
    • Amount of CCC-rated debt outstanding currently stands 65% above the record set in the last cycle
  • Quality of debt:
    • Average debt multiple of EBITDA on large corporate loans is just above the previous high set in 2007; the average multiple on large LBO loans is just below the 2007 high; and the average multiple on middle market loans is at a clear all-time high
    • $375bn of covenant-lite loans were issued in 2017, up from $97bn in 2007
    • BB-rated high yield bonds are now coming to market with the looser covenants common in investment grade bonds
    • More than 30% of LBO loans incorporate “EBITDA adjustments” versus roughly 7% 10 years ago
    • Loans to raise money for stock buybacks or dividends to equity owners are back to pre-crisis levels
    • All-in yield spread on BB/BB- institutional loans is down to 200-250bps, as opposed to roughly 300-400bps in late 2007/early 2008. Spreads on B+/B loans also have narrowed by 100-150 bps
  • Equities are priced high but not extremely high – especially relative to other asset classes – and are unlikely to be the principal source of trouble for the financial markets. I find the position of equities today similar to that in 2005-06, from which they played little or no role in precipitating the Crisis. Instead of equities, the main building blocks for the Crisis of 07-08 were sub-prime MBS, other structured and levered investment products fashioned from debt, and derivatives
    • In other words, not securities and debt instruments themselves, but the uses to which they were put
  • Conditions overall aren’t nearly as bad as they were in 2007, when banks were levered 32-to-1. Thus I am not describing a credit bubble or predicting a resulting crash
  • The possible effects of economic overstimulation, increasing inflation, contractionary monetary policy, rising interest rates, rising corporate debt service burdens, soaring government deficits and escalating trade disputes do create uncertainty

Howard Marks, CFA, is the Co-Chairman of Oaktree Capital, an alternative investment management firm he co-founded in 1995.

Howard Marks Memo: The Seven Worst Words in the World, September 26, 2018

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