Oaktree Takes Root : Junk Bond Pros Base New Firm on Old Ideas
Howard Marks has met plenty of corporate junk bonds he didn’t like. But as for the junk bond market as a whole, he insists there has rarely--if ever--been a bad time to buy a diversified portfolio.
“Cheap as usual” has long been his standard reply when asked by institutions or individuals how he views the junk market’s relative appeal.
Simplistic as it sounds, Marks’ philosophy about high-yield junk bonds--the now $300-billion market of debt issued by often mid-sized companies judged to be less than investment grade--has helped make him one of country’s most respected players in that arena.
But he has been forced to repeat that basic message for scores of his longtime clients nationwide in recent months. After 10 years with giant money management firm Trust Co. of the West in Los Angeles, Marks and four other TCW officers abruptly left to form a rival firm in March, in what became a high-profile and openly bitter Wall Street divorce.
At the age of 48, Marks says, he simply decided it was time to run his own show, a venture his TCW peers Bruce Karsh, Larry Keele, Richard Masson and Sheldon Stone were eager to join.
Not surprisingly, however, TCW Chairman Robert A. Day was unwilling to merely allow Marks and his associates to walk away with the nearly $7 billion in client assets they had built up in their tenure at TCW--a hefty chunk of TCW’s total $48 billion under management.
What followed was a high-stakes battle for the hearts and dollars of the TCW institutional clients whose funds had been managed directly by Marks’ team. The clients would have to choose between Marks and the in-house and outside managers TCW hurriedly named to fill the void.
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Now, three months after Marks’ new Oaktree Capital Management opened its doors in Downtown Los Angeles, both Oaktree and TCW claim to be satisfied so far with the outcome.
More than 30 big-name clients have switched $1.5 billion in junk-bond and convertible-bond assets from TCW to Oaktree, Marks says. By agreement with TCW, Oaktree also continues to manage about $2.5 billion in TCW’s “special-credits” funds, which hold distressed securities of troubled or bankrupt companies.
Although that still leaves TCW with a large portion of the original $7 billion that Marks oversaw, many clients may still be mulling whether to switch. Nonetheless, “We’ve been pleasantly surprised,” says Marc I. Stern, president of TCW Group. “We’re ahead of what our projections were” in terms of retaining clients, he says.
Although both sides privately admit that the fight for business has been bruising--a tone TCW’s Day set when he called Marks’ defection “disloyal at the very least” in a March letter to TCW employees--some of the institutional clients caught in the middle give both TCW and Oaktree credit for their handling of the split.
“From our perspective it’s been a happy resolution,” said Joseph Braccia, director of public markets for the Pennsylvania State Employees Retirement System, which has $100 million invested in the TCW special-credits funds.
By allowing Oaktree to continue managing the special-credits funds, Braccia says TCW wisely avoided the trouble that might have ensued by bringing in new managers to oversee portfolios that Karsh and Masson had hand-picked--and whose future payoff depends in part on their negotiating skills (e.g., with bankruptcy committees).
At the same time, TCW and Oaktree have managed not to sue each other over personnel issues, even though Marks has lured from TCW most of the professional staff he had hired there, bringing Oaktree’s total head count to 50 now.
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Marks’ ability to keep his old team intact is one indication of the high regard he enjoyed within TCW and within the investment business generally. In fact, some of his competitors wondered why he waited as long as he did to leave TCW and go it alone.
But some industry veterans say Marks’ timing probably couldn’t be better and that Oaktree’s formation is part of a wave of change in the relatively small fraternity of money managers in the junk-bond and distressed-debt arena.
“We’re seeing a lot of movement of managers--probably as much as we’ve ever seen in the high-yield business,” says Kingman Penniman, director of junk-bond research for credit-rating agency Duff & Phelps Inc.
In large part, Penniman says, the jockeying for position reflects a sense that “high-yield is finally coming to be recognized as a credible asset class by itself,” like high-quality bonds and stocks.
Although the junk bond business is roughly 20 years old, for most of that period it has been viewed suspiciously by many pension funds and other institutional managers who have questioned the long-term viability of the market and the potential reward for the level of risk involved.
It didn’t help, of course, that the godfather of junk--Michael Milken--ended up in prison, helping to precipitate the market’s collapse in 1989 and ’90.
Yet junk bond values came roaring back after 1990, producing stellar returns that helped Oaktree’s Marks cement his reputation with clients.
In the eyes of many consultants who advise pension funds on where to invest, junk bonds have been through the acid test, and have passed it.
“Our feeling is that high-yield bonds do have a long-term role to play” in investors’ portfolios, says Stephen Nesbitt, senior vice president at pension consultant Wilshire Associates.
None of which comes as much of a surprise to Howard Marks. His research into junk bonds began in 1978 when he was a bond portfolio manager at Citicorp. By 1985, TCW’s Robert Day recognized that Marks was pioneering the development of a lucrative class of securities and brought him in to head TCW’s high-yield department.
Marks’ investment case for junk bonds (like most pros in the field, he prefers to call them high-yield bonds) is disarmingly simple: The yields on the bonds are so high that they more than adequately compensate for the inevitable defaults that will occur within a diversified portfolio of the securities, he says.
Historically, junk bond yields have averaged three to five full percentage points above yields on 10-year Treasury notes, the risk-free yardstick against which junk is usually measured.
At the end of the second quarter, for example, the yield on the CS First Boston index of junk bonds was 10.67%, or 4.47 percentage points above the 10-year T-note yield of 6.20%.
But how much of that average junk yield will later be trimmed by losses on bonds that default? Very little, Marks insists--if, as he and his peers do, an investor plans to buy and hold plain-vanilla high-yield bonds at the conservative end of the junk spectrum.
Over the past 20 years, he says, his portfolio returns have been reduced by just 0.70 percentage point a year by the relative handful of surprise defaults.
“Figure it out,” says Marks. “I believe high-yield is one of the great free lunches in the [investment] business.”
Exactly why that should still be so baffles even Marks. He theorizes that prejudices die hard, and that many institutional and individual investors just can’t overcome the “junk” tag on what for the most part are decent, albeit less than blue-chip, corporate borrowers.
Bond-rating agencies “don’t ask ‘How much does it pay?’--they just say ‘it’s a bad investment’ ” compared to other bonds, Marks says. “But there’s no investment so bad that it’s not attractive at a price.”
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That is also the philosophy that guides Oaktree in its other major business: investment in distressed securities, the specialty of Karsh and Masson.
Marks hired Karsh, now 39, away from insurance firm SunAmerica in 1987. The idea was for Karsh to invest client funds in securities of bankrupt or near-bankrupt companies if there was good reason to believe the market had underestimated the payoff potential of those securities.
Subsequently, Karsh has bought troubled real estate, bad bank loans and other assets tossed on the market at fire-sale prices.
Although by definition distressed investing is high-risk--and extremely research- and legal-intensive--the payoffs from TCW’s special credits funds have been phenomenal. The early funds produced 40% annualized returns.
And although returns have shrunk recently to the 20% range--a function of the strength of the economy and relative dearth of troubled securities since 1992--Karsh says the payoff from distressed credits will rise again with the next downturn in the U.S. and global economies, when more securities will inevitably go bad.
In that sense, Karsh says with a laugh, “Our biggest enemy would be [an economic] soft landing.”
Which may seem to contradict what Marks would want for the sake of his junk bond portfolio, but the two men see more similarities than differences in their strategies: Marks wants to own good bonds that others view as bad; Karsh wants to own bad bonds that are better than they look.
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Junk: Attractive as Usual?
Howard Marks’ simple philosophy about junk corporate bonds is that their high yields compensate for the risk involved, and then some. The spread between junk yields and yields on super-safe U.S. Treasury securities may vary over time, but it’s never too little to make junk bonds unattractive, Marks argues. Average yields, end of each quarter:
Junk bonds (1995): 10.67%
10-year Treasury notes (1995): 6.20%
Source: CS First Boston Corp.
Junk vs. Stocks and Treasuries
Based on calendar-year total returns since 1982, corporate junk bonds have beaten 10-year Treasury returns and the Standard & Poor’s 500-stock index in five of the 13 years; junk has beaten Treasuries alone in eight of those years. Total returns are interest or dividends earned plus or minus any change in principal value.
* indicates best-performing of the three markets that year
Year Junk bonds** 10-year Treasuries S&P; 500 stocks 1982 +36.6%* +32.0% +21.6% 1983 +13.9 +3.5 +22.6* 1984 +10.7 +12.9* +6.2 1985 +24.9 +26.3 +31.7* 1986 +15.6 +19.9* +18.7 1987 +6.5* -1.9 +5.2 1988 +13.7 +6.1 +16.4* 1989 +0.4 +16.6 +31.5* 1990 -6.4 +6.8* -3.1 1991 +43.8* +16.5 +30.5 1992 +16.7* +6.5 +7.6 1993 +18.9* +11.9 +10.1 1994 -1.0 -6.1 +1.3* 1995 +10.8 +15.3 +20.2
** CS First Boston high-yield bond index
1995 data through June 30
Source: CS First Boston Corp.
