Two icons of distressed investing – Bruce Richards and Lou Hanover, who together run the $15 billion Marathon Asset Management – gave a lengthy interview to Barron’s last week, in which they laid out their views for 2019, and perhaps surprisingly had a generally sanguine “best case” outlook for the asset class that makes up their bread and butter, namely junk bonds, saying that “high yield should do pretty well, contrary to what most people think. Because growth rates are at 2% and earnings are still improving, default rates will remain low. Spreads are blowing out already; now you’re getting paid 7-7.5% yield. You may not earn the full 7, 7.5%, but we think you’ll earn 3 to 5.”
The distressed duo also noted their preferred investment for 2019, saying that while emerging markets are the most volatile of all the credit markets, their “top expected return for this year is playing Argentina” which based on how much it backed up last year, “it’s offering very, very good value.”
It’s not until you have some more certainty around Macri and this election (in October) that you want to start to deploying capital aggressively. Right now, for a trade, we’re beginning to buy.
That said, there are distinct risks to their outlook, with Richards and Hanover noting the following four major risk factors:
- Is the Fed moving too aggressively?
- inflation expectations.
- will negotiations with China turn into an all-out trade war, where the impact to the economy could be at least 50 basis points of GDP.
- Europe: is it hard Brexit? Is it Italian recession? Is the transition from Merkel going smoothly? In the latest quarter, German GDP really slowed. Will the yellow jackets in France gain prominence and try for political change? Then there is Mario Draghi and the ECB: one of our top expectations for next year is that European investment grade and high yield become considerably cheaper because the ECB moves from QE to a neutral stance when they begin raising rates. Europe needs an easy policy, but the zero rate environment is creating some other issues, like bubbles in some of the sovereigns.
Also, following the recent rout in investment grade bonds, which have “gotten clobbered” Marathon likes it, even if they remain concerned about the BBB-tranche “There was $760 billion of BBB U.S. corporate bonds in year-end ‘07. Today, that’s $3.15 trillion.”
As a result, Marathon is starting to set up a basket of shorts in BBBs, in bonds, and CDS: “We’re focused on investment grade, the most highly leveraged single-names.”
Meanwhile, while generally sanguine on High Yield, Marathon lays out a laundry list of key concerns involving high yield bonds, starting with the fact that the vast majority of debt nowadays is covenant lite. And, as a result of this prepondrance of covenant-lite debt, Richards forecasts that default rates will stay well lower than prior distressed cycles, largely as a result of reduced negotiating leverage that creditors have, however, once defaults do hit eventually, the result will be far lower recovery rates “because they’ve eaten away a lot of value.”
Less than 20% of all loans a dozen years ago were covenant-lite, and 80% had strong covenants. Today’s the reverse. (Covenants) get you to the negotiating table. In the next distressed cycle, for that exact reason, we expect the default rate will only go to 7 instead of 10. Default rates measure trailing 12 months. At some point, a deferment will lead to restructuring, and that might lead to lower recovery rates, because they’ve eaten away a lot of value.
Meanwhile, Hanover metaphorically predict that “It’s little lap waves hitting the beach” that will lead to the most damage:
You’ve got a little stress in retail, so you see this in Neiman Marcus and PetSmart: I lend you $100 million to buy that building, and six months later you dividend half of it out to yourself. Who would do a mortgage where you could lose half the collateral? That’s the market funding (PetSmart’s) purchase of Chewy; they dividended 35% of it out. That’s set the stage for a fight with creditors. That was right in the document; that wasn’t even trickery. It’s going to keep happening in different industry verticals.
Finally, comparing what the downside case could look like when comparing the financial crisis and the upcoming distressed cycle, Hanover is quite visually gloomy:
In ‘08, you had the big crash, and pop; this is going to be pain, pain, pain, distress exchanges, rescue financing, and then doing whatever you can do with the (capital) structure: grabbing collateral, making yourself more senior, delaying the day. Maybe some companies recover; a lot don’t. It’s going to roll to one sector after another.
Finally, with regard to when the two see the next distressed cycle finally hitting, their answer: the latter half of 2019 or 2020.
This year we harvest a lot of what we have and let cash start to build up. We’re setting up for a very, very big distressed opportunity, whether it’s the latter half of this year, end of this year, or into the following year.