Credit Where It's Due

An Interview with Boaz Weinstein

Weinstein: It is not hard to find people saying, "Equity valuations are high. There's not much equity risk premium. Credit valuations are high. There's not much credit risk premium." In late June Goldman Sachs put out research suggesting that CCC-rated debt doesn’t even offer enough spread to cover defaults -- much less enough to cover market to market risk and illiquidity premiums and the like.

We have been in this world before. High yield with a five-year spread of 350 basis points is low, but by no means unusual. The range has been 250 to 2000, and with default rates having been quite low for the past 25 years, I don’t think the current low spread is particularly extreme -- especially compared to even lower equity volatility. Credit curves are very steep, so an investor in the five-year sector has some decent chance for price appreciation as the five-year becomes a four-year and so on.

That said, I do see great complacency in a part of the high yield market -- particularly with companies where the equity has suffered greatly. We are tracking over 100 companies globally who have seen equity declines of 60 to 70 percent minimum over the past year and have a junk rating, yet their debt is still trading at a price in the mid-90’s or higher. Often the credit and equity markets are in synch, but occasionally one market is leading the other by a few months. If we look at the few credit blowups that actually have occurred of late, the equity market was signaling great stress and investors ignored the signs. Notably, Banco Popular in Spain and Noble SP in Singapore both recently saw their debt collapse months after the equity had collapsed.

OR: What are your favorite names?

Weinstein: Hertz is a good example. The stock fell from $50 to $9 in under a year, but the three-year debt still is in the mid-90’s despite unsecured debt being nearly 10 times levered. A stock that can have such a fall despite bearish sentiment all year long is a sign that the analysts’ models are failing to keep up with an even bleaker reality. And once the stress becomes as great as it is now, further disappointing results in my view will lead to a sort of "tripwire" where the debt can suffer an even greater decline than the equity as it quickly makes up for lost time.

Other companies that more or less fit the same description are Frontier Communications, Windstream, Community Health, Supervalu, New Gold, SM Energy, Dynegy, Avon Products, and JC Penney. Of course, an alternate possibility is that in some of these cases the debt market has it right and these stocks have been oversold.

OR: How do you think this portfolio -- or volatility in general -- would react to a change in interest rates?

Weinstein: People have been worried about higher interest rates for so long. Though that doesn't mean they're at all prepared for it. It's also been a "Chicken Little" call for a number of years. So few hikes are priced into market expectations compared to the dot plot; someday there may be a day of reckoning, but it is likely still far off and maybe the market's going to continue to discount that outcome until the bitter end.

OR: Can you talk about your career as a value investor and your closed-end thesis and how it’s been playing out?

Weinstein: I think discounted closed-end funds (CEFs) are the best long opportunity at present, and also fairly simple to understand. It’s a rare corner of the market where retail investors can get an edge over institutions: most institutions don’t realize that it is a large enough market to matter to them.

There are approximately 540 tickers on the New York Stock Exchange of different CEFs, totaling $240 billion in market value with about an even split between equity and fixed income. They are generally managed by top tier firms like Blackstone, BlackRock, PIMCO, DoubleLine, and dozens of others. Because of some peculiar dynamics around the Bernanke taper tantrum in 2013, investors went from being large buyers of closed-end funds to sellers. That downward pressure moved the closed-end funds from trading at a premium to net asset value to a deep discount to net asset value.

Although CEF discounts have narrowed in the past year, it’s possible to buy a few dozen of them at an average 10 percent discount without sacrificing quality. You go into it hoping the discount will narrow on its own, but one of the nicest points about this investment is that while you wait, you earn an above average yield, given the discounted price. If enough time passes without the discount narrowing, a dedicated buyer like Saba Capital might find itself the largest holder of the fund and then the "suggestivism/activism" side commences. Over the past two years many managers, from Alliance Bernstein to UBS, have announced steps that fully collapse the discount such as liquidation or open-ending their funds. We have found ourselves invested in the majority of these situations and, in many cases, the driver of the shareholder friendly campaign.

We currently hold about $1 billion of CEFs, and in the past few months launched an actively managed ETF (ticker CEFS). We view CEFs as a better way to own credit risk than CLOs or ETFs such as HYG or JNK due to the discount to NAV of the portfolio and the mechanism for narrowing the discount. Though most institutional fixed income investors have never owned a CEF, the largest individual holder is none other than Bill Gross who (according to public filings) still owns over $140 million of PIMCO CEFs. In addition, Jeff Gundlach, who currently is called the Bond King, has issued CEFs and frequently recommends buying other managers’ CEFs when at a discount.