A Turning Point in the Bond Markets

"It is always darkest just before the dawn." This very old and somewhat trite saying, is nevertheless very true (unless the moon happens to be high in the sky at 4am). It goes for our financial markets and the economy as well. We are in the deepest economic decline since the Great Depression. And if not for quick action by our Federal government, we might even exceed the depths of "The Greatest". Whether you agree or disagree with the philosophy of a central bank that interposes itself into market workings, it is hard to deny it is having some effect.

Yesterday, Ben Bernanke shocked the world by dropping the overnight Fed Funds rate (rate at which banks can borrow very short term from the Fed) to 0-0.25%. Basically, free money. In one way, this is just recognition that is where the short term Treasury rates are anyway. No point in keeping the overnite rate at 1.0% when the 3 month and 6 month Treasury bonds are yielding 0.01% and 0.2% respectively as of today. For these rates to be good investments, the currency MUST deflate (each dollar be worth more at a later date). But more likely, the buyer of such Treasuries just is making sure he still has tomorrow what he has today.

The past few weeks have also put to bed any notion that Gold is the world's safe haven currency. There has never been a time, probably not even the 1930s, when such a currency has been more in demand than right now. Yet, what do the world's investors flee to in times of absolute financial terror? Gold?.... No way....US Treasuries, instead. The irony is that the more money the Feds print, the more expensive it gets as measured by higher priced / lower yield US Treasury bonds. What a deal the Feds have (and by extension, we taxpayers). This anomaly is allowing the Fed and Treasury to buy up all the toxic mortgage and corporate debt at almost no cost to the taxpayer, at least not yet!

What this all suggests is that we are at another bottom of sorts, a yield bottom. Or to take the inverse, we are at a Treasury bond market top. Tops and bottoms when they can be identified, always make for a good time to evaluate a position and make changes to it. There are two possible routes in the bond world that make excellent sense at this time. One, go short the Treasury bonds by selling short Treasury ETFs, like (IEF), or by buying Ultrashort Treasury ETFs like (PST).

Another really good strategy at a yield bottom like now, is to go to the other end of the credit quality spectrum and buy the hated high yield (junk) bonds that now at historic spreads (differentials) to Treasuries. Even James Grant, a super-contrarian who called the credit and market crash years before it happened, likes high yield corporates and senior bank notes at this stage (see below). Today's high yield bonds are at a 20% spread over Treasuries (which is to say they are yielding right about 20% with Treasuries near zero). The normal spread of high yield corporates over Treasuries is around 6-7%, and the spread was as low as 4% in 2006. There will eventually be a reversion to the mean. Moving from 20% spread to 7% spread should result in at least a double for the high yield market. In the meantime, reinvest the 20% annual dividends to buy more fund shares.

I am counting on the Fed fiscal and monetary actions to turn around the economy, forestalling any wide spread defaults on corporate debt. I personally have loaded up on junk funds. I am buying into the Fidelity Advisor High Income fund (SPHIX). Another good mutual fund I have owned in the past (in 2002-03 before the recovery in that cycle) is Vanguard's High Yield, (VWEHX). A new low cost IShares ETF is also available under the ticker (HYG). I have done a comparison and all three trade in lockstep and have a similar yield around 12% as of today (a little lower than the junk bond universe because the quality is somewhat better in these funds). So, pick your favorite fund company and go with it.

Here is what James Grant said yesterday about a similar class of investments, senior bank loans, which have been heavily sold as a result of the hedge fund unwind. Senior bank loans were part of the "carry trade" play, with hedge funds borrowing short term, low interest loans like Japanese bonds, and then buying higher yielding funds like the senior bank loans. As hedge funds were forced to meet redemptions the past six months, Seniors and High Yields, were sold off indiscriminately:

Grant Says Forced Sales Create Opportunities in Bonds

By Carol Massar and Gabrielle Coppola
Dec. 17 (Bloomberg) --

Investors seeking safety in Treasuries may be missing out on opportunities created by forced selling in credit markets, according to James Grant, editor of Grant’s Interest Rate Observer.
Investment-grade corporate bonds are paying record yields relative to benchmark rates, “in this time of zero yield elsewhere,” Grant said today in a Bloomberg Television interview. Residential mortgage-backed securities and bank loans secured by assets are also attractive now because money managers forced to dump the securities to meet investor redemptions have made them artificially cheap, he said.

Yields on investment-grade bonds relative to benchmark rates have hovered near record highs as investors shun all but the safest debt in the deepest economic crisis since the Great Depression. The Federal Reserve cut its benchmark interest rate to as little as zero yesterday, further reducing yields on Treasuries, to try to ease the yearlong recession.

“Of course there’s trouble, that’s why there’s a bear market,” Grant said. “But that’s when you’re supposed to be interested in value. It’s not when everyone’s happy.”

The average yield over benchmark rates on investment-grade corporate bonds was 651 basis points yesterday, 5 basis points shy of the record high set Dec. 5, according to Merrill Lynch & Co.’s U.S. Corporate Master index. A basis point is 0.01 percentage point.

Market ‘Anomalies’

Forced selling may be distorting prices for secured bank loans. Senior bank loans that are higher up in the capital structure of a bank, meaning owners of the bonds would be paid before other debtors in the event of a default, are trading at lower levels than junior portions of the structure, he said. That means safer loans are cheaper than their riskier counterparts.

“All these anomalies are part and parcel of the liquidation in the credit market,” Grant said.

“That’s why we’re bullish on credit, because so many things simply don’t add up.”

Grant is the founder of Grant’s Interest Rate Observer, a financial journal. He was a columnist for Barron’s before founding the Observer in 1983.

Leverage Bank Loans - Great Returns with Limited Risk

In today’s Barrons (I get online a couple days early) there is a good article on commercial bank loan funds, which is the same as floating-rate funds. We have liked these, although I have been early with DWS Dreman Value Fund (DHG). I think you liked a Van Kampen version of this type of investment. The interview is encouraging for the future of this investment. I just checked mine, and though it is paying 11% dividend against today’s price, with my higher cost basis (from purchases last year), I am averaging around 8.5% yield, which is still very good. And there is a lot of market price upside. DHG is trading for 13.35 as of yesterday. But the NAV is almost 16. So it is trading at a 16% discount to NAV. When the market starts liking these investments, that discount will narrow or disappear. The NAV should climb as the market begins pricing up the previously discounted bank loans for the reasons in the article. Bank loans have variable rate interest, so are not exposed to inflation risk (which is why I got into these in the first place).

Note that the TXU debt that Steve Tananbaum likes in the article, is the no. 1 holding of DHG, which is managed by Dan Dreman and his team for DWS.

From Barrons, Monday, April 21, 2008

Leveraged Loans: Ready for Lift-Off
Says Steve Tananbaum of GoldenTree Asset
By LAWRENCE C. STRAUSS



STEVE TANANBAUM'S ROOTS ARE IN HIGH-YIELD BONDS, which he began analyzing at MacKay Shields in 1989. He became head of the department two years later, while still in his mid-20s. Since then his horizons have expanded to all sorts of asset classes, including equities. No surprise, he remains a value investor.

Eager to run his own firm, Tananbaum left the mutual-fund world in 2000 and launched GoldenTree Asset Management. With nearly $14 billion in assets, much of it in hedge funds, the New York firm devotes a lot of its time and energy to alternative assets. One of Tananbaum's favorite investment themes right now is bank loans used to fund leveraged buyouts. Amid the credit crunch, which has caused the spread between yields on high-yield bonds and Treasuries to widen, these loans have come under pressure. This kind of debt isn't widely available to retail investors, though some mutual funds, such as Eaton Vance Floating Rate Fund (ticker: EVBLX) and AIM Floating Rate Fund (AFRAX), specialize in bank loans.



Steve Tananbaum

So-called loan-participation funds haven't done well lately, and are down about 4% year to date through April 14, according to Lipper. But that's better than the broader market's total return of minus 9%. GoldenTree's flagship offering, the $5 billion Master Fund I, which looks for value in equities and bonds, was down 5.39% in this year's first quarter, but more than two percentage points ahead of the Merrill Lynch high-yield credit index that's used as a benchmark. The fund's five-year annual return of 11.34% bests the high-yield index by nearly three percentage points, as of March 31.

Barron's recently caught up with Tananbaum, 42, at his midtown office, which houses a portion of his art collection, including the spacesuits by artist Tom Sachs shown in the photo at right.

Barron's: What is happening in the credit markets, where conditions since August have been very tough?

Tananbaum: The credit problems that started last year, and which were perceived to be isolated, really spread throughout the system. In different pockets of credit, things were mispriced. Right now you're seeing a repricing of credit. Whereas last year you were being underpaid to own credit, now you are being overpaid.

You mean, in terms of much wider spreads?

That's right. Against that backdrop, the investment banks have been damaged. Normally they provide credit to the financial system. But things aren't working the way they normally do. You're seeing the banks' inability to provide credit to a lot of their corporate customers.

Are the banks lending less because they have to put more of assets on their balance sheets?

The banks are playing defense. They are more worried about their current relationships than beginning new relationships.

Are hedge funds paying higher interest rates to borrow from banks?

The terms are different from what they were six months ago. The banks are looking to provide less leverage at wider spreads, and only on larger pools of assets.

How has that impacted GoldenTree?

First of all, most of the money we run isn't levered. We have about $10 billion of alternative assets, of which $7 billion to $8 billion doesn't have any leverage associated with it. Also, we have favorable terms, with four to five years left on our credit facilities, so nothing is coming due right away. Having said that, if you have access to borrowing money, then bank debt, or leveraged loans, is very attractive. That's because the spreads on bank debt have widened considerably, to somewhere around 600 basis points [six percentage points] above Libor [the London interbank offered rate], meaning the prices have come down significantly. Those spreads are as wide as they've ever been. In the next two years, you could see spreads going back down to 400 basis points. That would give you double-digit returns over the next two years.

So this is a good time to be buying?

This is a great opportunity to be buying. It reminds me of earlier credit crises, such as the ones involving Mexico in 1994 and Russia in 1998, and the one that unfolded at the end of 2000. It was clear: The markets correctly predicted that defaults would pick up, and there is usually indiscriminate selling at those points. That's what we have today. But the credit market right now favors those with the money to buy. Earlier in the year, some of the easiest purchases were investment-grade names like American Express [AXP]. It had a new debt issue that was trading 362 basis points, or 3.62 percentage points, over Treasuries. That's what the high-yield index was yielding about a year ago. Now that debt's spread is in the mid-200s above Treasuries, meaning the price has appreciated. But there was definitely a disconnect.

What was driving bond prices to such low levels?

Leverage was a big part of the story. The first phase, as I said, was indiscriminate selling, much of it driven by a lack of liquidity. A lot of people had taken out lines of credit, leveraging up in some cases on bank debt, or loans used to finance buyout deals. When the value of the bonds went down, say 10 points, these investors got margin calls and were forced to liquidate, because they couldn't come up with any equity. It was basically a bunch of margin calls in February, and then in March it became a systemic issue with Bear Stearns [BSC].

What is your take on Bear Stearns' collapse last month, and its pending acquisition for about $10 a share by JPMorgan Chase [JPM]?

The Bear Stearns situation initially was about whether fraud was involved. The market got comfortable that it wasn't about fraud, but more about Bear not having the right capital structure. Then there was a run on the bank. The market has gotten healthier since the Bear episode, and the Fed has done a terrific job providing liquidity and telegraphing they intend to provide more.

What's the next step in the credit markets?

On the debt side, it's about finding companies whose balance sheets work. By that I mean which companies are self-sustaining in the current environment, as opposed to which balance sheets potentially are at risk of defaulting. The debt of Calpine [CPN], which has emerged from bankruptcy protection, was a large holding for the investment banks. Calpine had too much debt. But now, after the restructuring, it's a healthy company. The leveraged loans of Clear Channel Communications [CCU], the radio and entertainment company whose buyout has been stalled, could be a more challenging investment.

Table: Tananbaum's Picks…

Do you hold Calpine bank debt?

Yes. On the bank-loan side, we are focusing much more on companies where we are at the top of the capital structure. Calpine and TXU Energy, the Texas utility taken private last year, are interesting loans.

What does it mean to have a good position in a company's capital structure?

It means you get paid before others if things go wrong. You're first in line, ahead of the common equity holders.

As investment opportunities, how do you view junk bonds versus leveraged loans?

A lot more leverage was used for investing in bank loans. There wasn't as much leverage in high yield. Bank debt had a lot of margin calls at the beginning of this year, creating buying opportunities. And because there was such an overhang from the investment banks that held these loans on their balance sheets, it was a more attractive market.

There was no forced selling in high-yield bonds. Thus, bank debt, which is more senior in a company's capital structure, fared worse than junk bonds that were more junior. Bank debt offers better relative value than high-yield bonds.

What is on the horizon for bank debt?

April is starting off terrific, but there will be twists and turns. At the end of the day, what is going to determine returns, whether for high-yield bonds or leveraged loans, is the performance of the company. When certain companies can't grow into their balance sheets -- they can't, in effect, make their debt payments -- that's going to create opportunities, as well.

Any examples?

First Data, a financial-services company that helps process credit-card transactions, comes to mind. They were taken private last year. They have a big capital structure, and it will be hard for them to pay off debt.

Bank loans aren't readily available to retail investors, though there are some bank-loan mutual funds. Let's talk about some themes that have a wider appeal.

We've always looked at arbitrage between the public and private markets. In equities, there was a big discount to the private-market values of deals. That's opened up some terrific values because there is no private-market value right now. Many companies, including some in the media industry, traditionally were valued off of private bids. Now, in many cases, there is no private- market value because deals can't get done.

Some argue it's still too early to get into bank debt. Should you wait?

It depends on the situation. If you're talking about retailers or home builders, absolutely, it's early. We are avoiding home builders and retailers. The bonds of home builders, particularly the investment-grade issues, look extremely rich. But that's not true of all industries. Some bank loans related to utilities look attractive. For those companies, it depends on the dynamics of the region a utility is operating in.

Tell us about some equity holdings.

The television market in general has very good fundamentals. This is a presidential- election year, and the expectation is this will be the biggest spending year ever for TV broadcasting in terms of advertising. We are long the equity of Sinclair Broadcasting Group [SBGI], which owns a string of television stations around the U.S. It's a well-managed company with strong free-cash flow. And they have been benefiting from retransmission.

Which is?

Basically, getting fees from cable companies for their stations. We also like some cable companies, including Time Warner [TWX]. These companies have always traded at discounts to their private-market values. But we expect them to have high-single-digit cash-flow growth this year. Warner has a catalyst, given that [President and Chief Executive Jeffrey] Bewkes has telegraphed he's going to be splitting up the company. Time Warner trades at a significant discount to what we think its intrinsic value is, and it doesn't have a lot of debt. We believe, whether it's through dividends or buying back shares, they are going to releverage their balance sheet.

Time Warner and other cable companies are pretty much going to deliver the growth rates they've achieved over the last 10 years, yet their valuations are around 40% of what they've been historically. As recently as six months ago, these cable companies had double-digit multiples, based on earnings before interest, taxes, depreciation and amortization. And you can buy them for roughly half that now.

Any other thoughts on the cable industry?

We like international cable a lot. There's less competition overseas and we feel good about earnings. Liberty Global [LBTYA], is our largest holding.

Where else do you see value?

With casinos, take a look at MGM Mirage [MGM] compared to Harrah's Entertainment [HET]. Recently you could buy the debt of Harrah's, which has a better collection of assets, yielding close to 15% and trading at six or seven times cash flow. At the same time, MGM's equity was trading at about 10 times cash flow. We felt Harrah's debt was a better buy. We were short some MGM equity earlier this month, given that growth in Las Vegas is under some pressure in this economic environment, but we covered after the shares went down. MGM is a terrific company, but it turned out to be a good short for us.

Thanks very much, Steve.