Navigating Cycles

Mark Twain is reputed to have said, “History doesn’t repeat itself, but it does rhyme.” This certainly holds true in the investment world. Due to the tendency of investors to forget lessons and repeat behavior, the supply of investment opportunities is cyclical in nature. Howard and I have been partners since 1987, and together we have lived through three very pronounced credit cycles. Each of these – like any cycle – has had a repeating up- and down-leg caused by its predecessor and characterized by the following stages:

I recently sat down with a diverse group of Oaktree investment professionals to discuss cycles, both past and present. I was joined by Sheldon Stone (Principal and Portfolio Manager, U.S. and Global High Yield Bonds), Edgar Lee (Portfolio Manager, Strategic Credit), Jordon Kruse (Co-Portfolio Manager, Special Situations), Armen Panossian (Co-Portfolio Manager, U.S. Senior Loans) and Rajath Shourie (Co-Portfolio Manager, Distressed Opportunities). What follows is an edited transcript of our discussion.

- Bruce Karsh,
Co-Chairman and Chief Investment Officer

Bruce Karsh: What are the key cycles in your investment area and in what stage are we in for the cycles that matter most to you?

Sheldon Stone, Principal and Portfolio Manager, U.S. and Global High Yield Bonds: The two cycles most relevant to high yield bond investors are the economic cycle and the credit cycle. Today, I believe we are in the early innings of a down-leg in both of these cycles.

Our High Yield Bond group also monitors the cycles that are unique to each business and determine supply and demand for their products.

Armen Panossian, Co-Portfolio Manager, U.S. Senior Loans: The cycles Sheldon mentions (the economic and credit cycles) are also important to senior loan investing. In addition, CLO formation activity – or the CLO cycle – is an important element in understanding demand for senior loans. CLOs hold about 50% of all senior loans in the U.S. market, so the pace of CLO formation is a very critical determinant of the demand for new issue loans coming to market. Relative to 12 or 24 months ago, we’ve seen an increase in the yield of liabilities across all parts of a CLO’s capital structure. As a result, demand for CLO equity has declined, slowing down CLO formation. This has contributed to a decline in U.S. senior loan new issuance and secondary-market trading.

Bruce Karsh: How does this credit cycle resemble and differ from past credit cycles?

Rajath Shourie, Co-Portfolio Manager, Distressed Opportunities: The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries. In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.

Jordon Kruse, Co-Portfolio Manager, Special Situations: I’ll focus on a comparison of the current down-leg to the one we experienced in 2008-09. They are similar in that both followed long periods of significant debt issuance, but different in that there is far less systemic risk today than there was in 2008- 09. A major driver of that risk was the substantial amount of bad mortgage securities held by large financial institutions that played a major role in the financial system at large.

Bruce Karsh: What is your expectation for defaults this year?

Sheldon Stone: The 2016 default rate for U.S. high yield bonds is projected to increase to between 5 and 6%. This compares to the 2015 default rate for U.S. high yield bonds of 2.8% and the 30-year average of 4%. While this 2016 estimate is higher than what we’ve seen since 2009, it is not meaningfully higher than normal observations.

As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy-related issuers.

Bruce Karsh: Given your views on past and present cycles, how are you positioning your portfolios?

Armen Panossian: In our U.S. Senior Loans strategy, we are adopting a more diversified and defensive approach, while managing our exposure to energy and commodities.

Rajath Shourie: During the dislocation we saw in January through mid-February of this year, we were able to invest in a diversified set of high-quality, public-debt opportunities. We invested in sectors where the distress was more palpable, and we focused on higher-quality companies. Similar to what Armen mentioned, the Distressed Opportunities strategy is treading with caution when investing in energy and commodities. We are also looking to be more aggressive when investing in sectors with less of a connection to the current downturn’s main drivers (e.g., China, low oil prices).

Edgar Lee, Portfolio Manager, Strategic Credit: In our Strategic Credit accounts, we are emphasizing seniority and security. We have taken profits on and traded out of high yield bonds following their strong performance thus far in 2016 and have redeployed those proceeds into more senior securities, and in particular, bank debt. Direct lending remains attractive as well, and we are looking to continue to add private loans to our portfolio in the coming months.

Jordon Kruse: The current market has afforded our strategy the opportunity to focus on secondary purchases. Currently, the most interesting opportunity set for us is middle-market companies that have exposure to energy. While we have avoided investing directly in exploration and production companies, our team has looked at investments in manufacturing and service businesses that have 15% to 30% of their revenues tied to commodities, but still generate a substantial amount of revenues in areas of the economy not particularly affected by the commodity cycle. We expect many of these businesses will restructure, and we will end up with a control stake.

Bruce Karsh: How has China’s slowdown influenced the cycle we’re currently living in?

Rajath Shourie: China is a big driver of demand in the sectors most central to this cycle, including energy, commodities, metals and mining. While there is no question that we are going to look to actively invest in these sectors, we will do so carefully, as the outlook for China seems murky.

Armen Panossian: In the Distressed Debt group, we talk about building an inventory of low-quality debt as a growing pile of kindling, preparing for a bonfire of distress once economic weakness ignites it. I think China will be what gets the kindling lit this time.

Jordon Kruse: Consistent with Oaktree’s investment philosophy, in the Special Situations area we are more micro than macro investors. As a result, we are focused on how China’s slowing has positively or negatively impacted specific businesses. In the early 2000s, a significant aspect of our team’s analysis and underwriting included calculating the impact that the migration of manufacturing to China would have on a business over the long term. Today, we are more focused on understanding a business’s revenue exposure to China. In many cases, low commodity prices are positive for U.S. businesses.

Bruce Karsh: Outside of China, what factors do you think are exerting the greatest impact on the current market environment?

Sheldon Stone: The obvious ones are low energy and commodity prices; however, those are linked to China. The other one worth highlighting is liquidity. Current trading markets are significantly less liquid, causing rapid changes from a buyer’s market to a seller’s without large trading volumes.

We estimate that today, banks are carrying about 20% of their 2007 peak inventory of senior loans and high yield bonds. As a result, banks are now looking for trades to cross, rather than putting their capital at risk. It doesn’t take much selling these days to move bond prices a fair amount.

Rajath Shourie: I completely agree with Sheldon. Prices have recently been declining dramatically because there’s a buyers’ strike at play, not because there is a lot of supply from forced sellers.

Bruce Karsh: Is a tremendous buying opportunity imminent or likely much further away? Do you think Oaktree’s substantial dry powder will be deployed over the next two years?

Rajath Shourie: Our Distressed Opportunities strategy currently has a lot of dry powder. In two years, I think we will be talking about having had a good buying opportunity, and we will have been happy to have spent some of our dry powder. That said, in two years we may not reflect on the period as favorably as we would in a scenario in which we’d spent all of our dry powder, realized every investment and made a profit. It is quite possible that two years from now, we might still be in the middle of a good buying opportunity. In other words, we foresee a long, gradual cycle, not cathartic.

Edgar Lee: I think one of the most important investing lessons I have learned at Oaktree is that you can’t call the bottom, so you have to be willing to average down and buy on the way to it. When the market moves lower over the next two years, we need to identify those securities that are trading at a discount to their intrinsic value in order to generate great returns for the long run. As long as we continue to stay committed to investing in credits with good value as they become cheaper, we will create a long-term advantage.

Jordon Kruse: For the Special Situations strategy, I think the next couple of years will present a great buying opportunity if there is an exogenous event “igniting the bonfire” – like Lehman’s bankruptcy filing did in 2008 – as Armen alluded to. In the absence of that type of event, I think we will see a good buying opportunity because of the tremendous amount of debt outstanding today. So many low-quality credit names are out there, and some percentage of those names won’t make it. Our team is targeting high-quality but over-leveraged companies we think will to need to restructure – ultimately these are the kinds of investments we think represent good buying opportunities at any time in the cycle.

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