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.
“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):
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).