Monday, February 25, 2013

Memo from Brooklyn (OAK's Preferred Rate)

Howard Marks released another memo the other day talking about the state of the high yield bond market today.  This is very relevant as I mentioned it as being a concern for Oaktree Capital (OAK) unitholders.  Anyway, here is the memo:   High Yield Bonds Today

There are some interesting points here, and for OAK unitholders, there are some especially relevant points, particularly with respect to the 8% preferred rate of return (he didn't mention it in the memo).

First, Marks reminds us that we can't predict what the markets will do.  Nobody knows.  Rates can go up.  They can go down.  Who the heck knows.  He also points out that high yield bond prices may go down if interest rates go up, but so will other bond prices.  And in fact, high yield bonds may have less price risk than others.  Read the memo to see why.

There are some other things from the memo that is very interesting and makes me scratch my head. 

First, here are some great points about the current OAK high yield portfolio:
  • The average spread  in the current portfolio is 490 basis points, which is actually at the high end of the historical range over the past three decades at OAK.
  • This more than compensates for the average default rate of 1.4%/year in OAK's portfolios over the past 27 years.
  • The portfolio can have a 9% default rate every year and the portfolio would still do better than treasuries.  OAK has never had any single year with a 9% default rate in their portfolio.
  • If they bought or held a bond currently yielding 5.7% and have an average default rate of 1.4% and a loss rate of 50% and lose 0.7%/year, that's still 5% return (before fees and price movements).  This is an attractive absolute return.

Marks says,
"While we believe spreads are attractive given the risks we see in our portfolios, it is true that there is little room for price upside, making the reward for risk taking limited" (my emphasis)
"Considering these factors, should investors sell their high yield bonds and wait for a better time to invest?  We don't think so, as market timing is next to impossible to do right..."

Fair enough.  But unitholders like OAK partly for the incentive fees that it can earn on the funds.  With a preferred rate of return of 8%, and as Marks says, a 5% attractive absolute return at current spreads and rate levels but "there is little room for price upside, making the reward for risk taking limited" can we not expect much in incentive fees going forward until interest rates 'normalize'?

Just out of curiosity, I flipped through the S-1 from last year's IPO again and my eyebrows went up.  I'm just trying to get a better handle on OAK's historical returns.

This chart shows the long term returns of OAK's high yield bond strategy going back to 1986.  The interesting thing here that I'm not sure I noticed at the time is that this is based on gross returns.  I assume that means before management and incentive fees.




So since the end of 1985 through the end of 2011, the high yield strategy gained 1069% and the benchmark gained 776%.  On an annualized basis that comes to 9.9%/year and 8.7%/year respectively.

This may not be apples to apples as this composite may include funds that don't have incentive fees and have varying levels of management fees.  But just looking at this raw data and applying 1.5% management fee and 20% incentive fees, this would show a net return to the investor of 6.7%.  So net of fees, OAK's high yield strategy failed to beat the benchmark index over 26 years?   I just took the 9.9%/year gross return, deducted 1.5% in management fees and then multiplied by 80% to get 6.7%. This may not be correct due to the 8% preferred rate and other things.

This is a little contrary to my image of OAK so I may be missing something here.  I would guess that the incentive fee generating funds are more opportunistic and had higher returns over time while this composite return may include lower risk, lower fee and larger funds.  That would make sense.

But still, I was a little surprised by this.

[Comment/clarification after the fact:  Please read comments in the comments section.  I did miss something. The high yield strategy are primarily the open-end funds which have management fees of 50 bps or so and presumably  no incentive fees.  There are other comments on the returns on the distressed debt funds that do have incentive fees.  So I did miss something! ]

Tailwind to Headwind?
Also, OAK has returned 9.9%/year over the past 26 years but that was during a time of steadily declining interest rates; OAK had a huge interest rate wind at their back that may turn into headwinds going forward.

In 1985, the 10 year treasury rate was 10.6% and that is down to 1.9% now.   Even using the late 1980s as a starting point, 10-year treasuries were in the mid 8% range.

So, two points come to mind:
  • OAK had a huge tailwind (rates from 8-10% down to less than 2%) since 1986.  Yes, 5% absolute returns in this environment is good, but what happens to returns over time without this tailwind?  Or if the tailwind turns into a headwind?
  • I don't know how the preferred rate of return has evolved over time, but if it hasn't changed, then back in the 1980s, they only had to outdo treasury rates to earn incentive fees.  Today, they have to earn 600 basis points more than treasuries before they get incentive fees.  Back then they only had to outdo treasuries, but today they have to outdo even the high yield averages by more than 200 bps before they can collect incentive fees.  Is this possible?! And again, that's with "little room for price upside".

Marks said the other day on the conference call that OAK has done OK with funds raised in good times and really well with funds raised in bad times. 

Here is a visual look at that statement (again, from the S-1):


So it's true (not that I doubt his words!).  The funds raised in 1990/1991 did spectacularly well.  The funds raised in 2001/2002 (when even the quality-loving Buffett was buying junk bonds) did amazingly well too.

And the great thing about OAK is that funds raised in boom times didn't do so bad.  There are basically two periods in OAK's past that this was the case.  The mid-to-late 1990s and the 2005-2007 period.   The returns on those funds were not so bad; 10%-12%-ish figures.

But let's look at what the 10-year treasury rates were back then.  In the 1995-1997 period, the 10-year yielded 6.5%.  In the 2005-2007 period, it yielded 4.5% or so.

Today?  it yields 1.9%.  Assuming they do just as well on a relative basis, this would put their returns below 8%.

[ Comment after the fact: The distressed debt funds have returned 18% after fees over time, so there isn't as much risk to future incentive fees as I thought initially due to the low rates.  The distressed debt funds that have incentive fees have more equity-like returns.  Maybe that should have been made more clear on the conference call with respect to the 8% preferred rate question.  (Maybe it was made more clear and I just missed it!) ] 

Difference Versus the Stock Market
OK, you can say high yield bonds are overvalued (even though maybe not on a relative basis).  But isn't the stock market overvalued too now and then?  Would you sell out of the stock market or Berkshire Hathaway or any other great business just because the stock market is overvalued at any given point?

The quick answer is no.  I wouldn't sell stocks even if the stock market was overvalued.  I would not even sell the stock market in general if I was an index investor.  Why?  

Earnings growth.   Bond coupons do not grow over time, but earnings do.  So if a bond was overvalued based on yield, it will most certainly be a cap on returns (well, there might be capital gains if rates go even lower).

But with stocks, even if you own the stock market at overvalued territory, over time, you can still earn a decent return.  The stock market return in the last century (10%/year or whatever it was) was only achievable to those who owned stocks regardless; they owned through 1929, 1965, 1972, 1987 etc...)

For example, there was no question that the stock market was overheated, overbought and overvalued in August of 1987.  I think it was pretty much as overvalued as it was in 1929 (according to the p/e ratio at least).    The p/e ratio was above 20x, maybe close to 30x p/e. 

The S&P 500 Index peaked out at around 340 in August 1987.  But even if you bought the very high, then, and held for ten years through August 1997, you would have returned 10%/year before dividends.   If you held throught August 2000, you would have earned 12%/year before dividends.  OK, 1997 and 2000 were high valuation years for the stock market.

But even if you held on until today (and I'm pretty sure the p/e ratio is lower today than in August 1987), you would have earned 6%/year, again, before dividends.  

How does this happen?  Earnings growth.  Even if the valuation goes down, if earnings grow, you can still earn a good return over time. 

Bond coupons do not grow so if you buy it dear, then you can't have earnings growth bail you out.  So it's a real cap on return in that sense. It's very hard to make a return higher than your yield at the time of purchase.  A valuation headwind can't be overcome by earnings growth (like the stock market can).

Conclusion
First of all, this is all shorter term stuff.  I do believe if you have faith in the management, it's a good business and you pay a reasonable price, things will turn out well.  I bet the folks at OAK will figure all of this stuff out and will be in a much better place over time.

But even Howard Marks cautions us that even if we can't predict the future, we have to be aware of cycles and where we are in them.

As an investor in OAK, I am very aware of where we seem to be in the interest rate cycle.   People have been calling for interest rates to bottom for a very, very long time.  But at some point, the risk/return becomes highly unfavorable.   Even Marks acknowledges that there is little room for further upside in price.

So where does that leave us?  If rates don't go down further, it seems highly unlikely that OAK will continue collecting incentive fees.  If rates stay flat (which is a high probability scenario given what happened in Japan), then OAK's funds may return the 5% or so that Marks illustrated in his memo.  In that case, OAK also wouldn't collect incentive fees.

The best scenario is a gradual rise in rates to more 'normal' levels.  But this would cause capital losses in OAK's current portfolios.  The trick would be how quickly prices move and how much funds can be raised and be put to work at higher rates to offset losses in current portfolios.  Ironically, a rapid rise in rates may be the best scenario, even though I can't imagine OAK's stock price not going down a lot in that scenario.

In any case, there is a fine line in thinking too much about the near term and being aware of long term trends and limits on what even great companies can do given the environment.  I know OAK is expanding into other strategies and regions, so some of the above concerns will be mitigated, but still...

I really respect Howard Marks and the folks at OAK and am a current unitholder, but given the above, I have to say I am a reluctant unitholder at this point.  


11 comments:

  1. Oaktree doesn't make 1.5/20 on their high yield AUM. They almost assuredly have no incentive fee on those funds so you aren't making an apples to apples observation. Also, I think Sheldon Stone wrote most of that memo. The memo says "this is in essence what Howard said..." and I don't think Howard Marks refers to himself in 3rd person.

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    1. Hi,

      I figured that would be part of it. Even still, with 1% management fee and no incentive fee, OAK has barely outperformed the index. This was not really my impression. I wish they would have used net returns in that chart.

      Thanks for commenting.

      Delete
    2. Actually, as I mention below, the open-end funds (presumably the HY strategy) have management fees of 50 bps.

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  2. You are mixing a few things up here. First, Marks is talking about the HY market as a whole, not OAK's HY funds, I'm pretty sure the yield and spread on OAK's funds are above market.

    Second, their HY strategy is actually a fairly small part of AUM and probably doesn't carry a 1.5/20, most of it is probably a vanilla 1% or so. The biggest portion of OAK's AUM are their distressed funds, which have a 17.5% NET return after paying fees and carry since inception. OAK's quarterly release has a couple of pages with fund by fund returns.

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    Replies
    1. Hi, thanks for commenting. The metrics at the top of my post, 490 bps spread etc... is specifically about OAK's HY portfolio.

      The high yield portfolio is probably the open-end funds, in which case the management fee is more like 50 bps. So there is outperformance in HY over time after all (but not a whole lot).

      The distressed funds have done well over time, especially in the funds that were launched in bad times.

      So I worry less now about the incentive fees in the future, even though we will probably need another 1990/91, 2001/2002 or 2008/2009. I guess it's inevitable that this happens.

      There is still a little concern, though, that they seem to be raising a lot of capital when times are good, contrary to their previous counter-cyclical nature. I wonder how the funds raised last year and this year will perform.

      I suppose we have to think of the distressed fund returns as much more equity-like in which case it wouldn't be as interest rate sensitive as the open-ended HY portfolio. Someone did mention that in a previous post.

      Anyway, thanks for commenting.

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  3. Very disappointing that they didn't use log returns as it makes it much harder to back out recent performance, but assuming cumulative gross returns were 410% vs. 270% as of 12/31/02 (roughly what I make them out to be) that means they've underperformed their benchmark since that time 9.65% vs. 10.05%.

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    Replies
    1. As stated in the comments above, the HY strategy is not a major part of the valuation of OAK. Since we are worried about and discussing incentive fees, that occurs in the distressed funds. If this is the case, the distressed funds do have equity-like returns so are not as rate sensitive as your typical HY portfolio.

      Anyway, I'm glad this discussion (above) happened. One great thing about blogging is that people will correct me and I learn.

      I still have a general concern about the interest rate environment, but it's not as strong as it comes across in the original post.

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  6. Any updates on OAK? They seem to be harvesting now that the markets have been rising steadily.

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    Replies
    1. Hi,

      No, but they had a really nice 1Q. OAK is really on fire, but of course, it should be with the markets doing what they are.

      One thing that was interesting is that during the 1Q conference call, they said that they are getting into retail distribution for their funds. They do subadvisory where the end-user is retail, but I think they said it's the first time they are going to go directly to retail. They made some hires and are developing the business.

      Things look really great there at OAK. I am not as worried as I sound in one of my posts these days, but I do worry a little bit as some areas might be getting a little bubbly.

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