Howard Marks, a well-regarded student of financial markets, is the founder and chairman of Oaktree Capital, which has made heaps of cash by savvy investments in distressed debt. (I’ve been gradually reading through his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.) The well has been running dry for distressed debt investors recently as central banks around the world have suppressed interest rates and provided extraordinarily cheap financing to corporations. As a result, corporate bankruptcies have been at historic lows; many companies that probably should be out of business (e.g., RadioShack, Sears, JC Penney) have been able to postpone judgment day by living off easy access to credit.
Marks presumably would be delighted to see the article from yesterday’s Wall Street Journal by John F. Wasik recommending that ordinary investors buy junk bond funds: “Junk Bonds Deserve a Place in Investors’ Portfolios.” For the more retail investors bid up the prices of junk bonds now, and they are already at historic highs, the more opportunity there will be for Marks when the credit cycle turns — and the current cycle is decidedly long in the tooth. Bloomberg reports that Marks is getting ready to pounce.
The world’s biggest distressed-debt investor is seeking $10 billion for a new fund with plans to sit on most of the capital until rising markets reverse course, three people with knowledge of the plans said. Oaktree plans to raise $3 billion that it can start investing immediately and $7 billion for a reserve pool to deploy when more distressed opportunities arise, said the people, who requested anonymity because the plans aren’t public….
The firm, led by Chairman Howard Marks, doesn’t expect the dry spell to last for long.
“Credit standards have dropped and non-investment grade debt issuances reached record levels,” John Frank, Oaktree’s managing principal, said July 31 on a conference call with investors and analysts. “Aggressive extensions of credit of the sort we’re seeing today have always been a precursor to a substantial distressed-debt opportunity.”
In his Journal article Wasik states, “In these yield-challenged times, there’s no sin in scavenging for an extra point or two in returns.” Junk bonds offer an extra point or two of income yield compared to investment-grade bonds, so Wasik says that retail investors should buy, so long as they recognize “there’s no need to load up on them”, since “[e]xperts generally advise putting no more than 5% of an income portfolio into junk bonds.” Although Wasik hedges his recommendation with such caveats, it’s still bad advice. Most investors don’t need to have any portion of their portfolio invested in junk bonds during ordinary times, and certainly not now when bonds generally are very expensive.
“Junk” bonds are so-called because they consist of risky loans to companies that have a fair chance of defaulting. The Wall Street euphemism for junk is “high yield,” since creditors usually are paid a premium for making such risky loans. The problem is that now risky bonds don’t pay any meaningful premium for the extra risk they entail; they’re not high-yield anymore, but they’re still junk. The average junk bond yield is currently close to the average historic yield on the one-year US Treasury, which investors usually think of the maximally liquid, risk-free asset. There couldn’t be a clearer sign that the market is mis-pricing risk.
In previous posts I’ve remarked on additional risks that arise when investors buy bonds through mutual funds or exchange-traded funds. Junk bond fund investors are subject not just to the risk that the borrowing companies will default on their bond payments, but to the liquidity risk inherent in the functioning of the funds they own. The size and liquidity of the secondary market in bonds has decreased markedly as big banks have been squeezed out of bond trading by new regulations. We’ve yet to see what the effect of this decrease in bond liquidity will be during a market correction.
In any case, the last thing that ordinary investors should do right now is go “scavenging for an extra point or two” in junk bond funds. If you’ve got as much money and patience as Marks, then you might afford to wait for the distressed-debt opportunities to arise. Otherwise, better to pass on junk altogether and stick with quality.