In a new year's market marked mainly by plunging asset classes, some of the most admired investors have found an asset class they think can make them money in 2016: to wit, high-yield corporate bonds.
A few days ago, institutional investor GMO put out its quarterly letter. As usual, most of the headlines focused on what its famed and outspoken principal Jeremy Grantham had to say - this time concerning his contrarian, upbeat view of the market this year. But it was Grantham's partner, Ben Inker, who laid out where the firm managing over $100 billion is actually putting its shareholder's cash.
In contrast to Grantham's macro view, Inker was quite "micro" in his detailing the rationale for his firm's investment in high yield - not to the point of naming his favorite bond issues but in explaining the numbers that lead GMO to regard high-yield corporate bonds as likely priced below fair value.
Before examining his case, it is worth noting that another very high profile and admired investor - DoubleLine Capital's Jeffrey Gundlach - agrees with Inker, though one might not readily grasp the point from the recent press coverage.
The headlines have focused on Gundlach's fears over bank stocks being priced at below financial crisis levels, which he views as a bearish sign. Bloomberg did well, however, to note that Gundlach has positive expectations for corporate bonds, though he believes such an investment is currently premature.
"The whole question for me is when am I going to buy enormous amounts of corporate credit, because it's crystal clear that that's the next opportunity that's out there," Bloomberg quotes Gundlach as saying. "There's plenty of things out there that will have 100 percent returns. It's a whole question of: Don't tell me what to buy, tell me when to buy it."
Strikingly then, Gundlach and Inker agree. Although GMO has been a buyer of corporate debt throughout 2015 and year-to-date as well, anyone who troubled to read Inker's analysis to the end would appreciate that in his last paragraph Inker states his "hunch [that] we are probably getting in a little early" but is likely doing so because of "the fear that we might not get all the exposure we would like" since he views it as impossible to call the turn.
In other words, according to these two distinguished investors, the best time to invest in corporate bonds has yet to materialize but is near at hand.
While it remains unclear why exactly Gundlach sees corporate credit as the next opportunity, Inker spells out exactly why corporate credit, and specifically high-yield debt, "seems to be an utterly classic value investing opportunity."
Widening Spreads (Increasing Returns) and Rising Defaults (Increasing Risk)
For starters, Inker says that at the end of January, high-yield credit spreads were "significantly wider than their long-term averages." What's more, the GMO manager says these spreads are widening, fueling the firm's desire to increase its holdings, though Inker warns "we are not yet leaping into high yield with both feet" (perhaps for the same reasons as Gundlach).
Inker is cautious because his firm is taking the conservative view that we are entering a new era of spiking defaults, an environment in which these securities will likely "overshoot fair value."
The GMO manager explains that he does not consider it sufficient to factor in long-term average default rates because default rates occur sporadically, in cycles, and thus their effects are extremely uneven from year to year.
"A yield spread over Treasuries that would give wonderful returns at a 1% default rate would leave you crying over your brokerage statement if we saw 15% instead."
As mentioned, GMO does in fact foresee a new default cycle - and not just for the hard-pressed energy and mining sectors. But just as an average default rate is insufficient for Inker's analysis, neither is he satisfied with broad extrapolations from economic conditions.
That is because the worst recession during the past three decades - amidst the Global Financial Crisis - produced the least bad default cycle during the period, while the mildest recession (in U.S. history, he says), amidst the dot-com implosion from 1998 to 2003, produced the worst default cycle.
Consequently, Inker crunches the numbers to see how buy-and-hold, high-yield investments would perform under a number of scenarios including a worst-case scenario where the annual default rate reached the same frequency as during the Great Depression (9.2%).
And while in that extreme case high-yield would underperform safe Treasuries by 0.4%, the securities would prove their worth in bullish, "normal" and even "bad" circumstances.
"The likely results over the next five years range from just about acceptable to wonderful in anything but the most dire default scenario," he says.
His bad case entails a 1.6% return over Treasuries, i.e., in circumstances as bad as another dot-com bust, when defaults were 7.7% annually. Meanwhile, normal times would see a 4.5% premium while in a good economy investors would see a 5.9% premium over safe Treasuries.
But before jumping in with both feet, as GMO is not doing, Inker reminds investors that unlike in stocks, credit default losses entail a permanent impairment of capital. Moreover, the universe of high-yield corporate bonds is not limited to those issued at BB and lower but include investment grade bonds that are downgraded to junk.
"Downgraded investment grade bonds can increase the size of the high yield market materially just at the time of the cycle where there is little appetite from investors to absorb more of them," he warns.
GMO plans to mitigate this risk through securities selection that naturally aims at high expected return and downside protection. But in general terms, in the institutional money manager's analysis, "at current spreads, high yield seems to be no worse than fair value and probably better than that even if we assume (as we do) that we are entering a…default cycle."