Coronavirus Roundtable - Bond Spreads And Default Risk (Video Transcript)

Summary

• We continue the Marketplace Coronavirus Roundtable series by speaking with Donald van Deventer of Corporate Bond Investor.
• He talks about how spreads blew out at the beginning of the market sell-off, how they've recovered, and where he's looking for opportunities.
• He also talks about why he doesn't look at high yield and the unfavorable comparison with lottery tickets.

Editors' Note: This is the transcript of the video we posted Sunday. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the video as well as a combined podcast featuring two other interviews along with this one, embedded below, if you need any clarification. We hope you enjoy.

Daniel Shvartsman: I'm Daniel Shvartsman, Director of the Seeking Alpha Marketplace. We're continuing our Coronavirus Roundtable Series. I'm speaking with Donald van Deventer, the author of Corporate Bond Investor, also the Founder of Kamakura. His service, Corporate Bond Investor, provides a daily ranking and weekly commentary on high-volume corporate bonds.

Listen and subscribe to the Marketplace Roundtable on these podcast platforms:

• iTunes/Apple Podcasts
• Spotify
• Stitcher
• Seeking Alpha

The conversation with Donald runs from 49:00-1:19:00 on the above podcast.

So, Donald, how are you? Nice to speak with you.

Donald van Deventer: Thanks, Daniel, very much to be with everybody today. It's a great pleasure. Forgive the telephone, I've got some construction on the floor above. Thanks to the work-from-home that's going on here in Honolulu for almost everyone but yours truly, and looking forward to some interesting conversation today about the fixed income market. So, I turn it back to you, Daniel, to pose the questions.

DS: Yes, absolutely. It's - we're all - as you say that I'm getting a phone call, we're all adapting to this environment. So, I wanted to start off with, we did a recent roundtable on fixed income. And one of the things and it's funny that we asked that and I still had March in mind and April has been quite different. We're recording this on April 30.

But you were talking about how spreads blew out as compared to default risk. And I'm curious what you're seeing now, as compared to that feeling, which I imagine was from the late March period? What are you seeing now in the fixed income sector, generally?

DvD: Okay, very good question. Let me start with a little bit of background. We update default probabilities daily on 40,500 firms in 76 countries around the world. And we have, what we call, a Troubled Company Index, that measures global credit conditions based on the default probabilities of those firms.

So, although, everyone is calling this the coronavirus crisis, what I want to point out before I answer your question more directly, is to say that at the end of February, before the markets really started to move in response to the virus, our Troubled Company Index was already showing credit conditions had dropped to the 14th percentile, where 100 is the best market conditions and zero is the worst. So, this is really - the virus is the trigger of the recognition of a bad economy that was already sliding pretty significantly before the virus crisis.

Now to answer your question more directly. In the first three weeks of March, there was - or three or four weeks of March, there was really an amazing explosion of credit spreads pretty much across the Board. We did a webinar yesterday. We were focused on one issue from JPMorgan, which is still got very, very reasonable default probabilities. But the bond price dropped almost six points from 105, down to a little over 99 at that point.

What's happened since the end of March, thanks in part to the Fed, but also, just to panic subsiding a little bit, credit spreads, generally speaking, they have come back to, I wouldn't say normal, but about halfway between what we would have regarded as normal at the end of February and the worst point that we saw in March. Those are for the good quality credits, and for people in travel, in hospitality, in energy, there hasn't been that recovery.

So, there's no question, there are some troubled companies out there who are not seeing improvement in spreads. But for the firms at the top of our rankings in the Corporate Bond Investor, people just, who stayed patient and the lucky ones who had some cash to buy into these widened spreads at the peak, are really reaping the benefits right now.

DS: So you mentioned that the sectors where they're not sound like the same sectors that are struggling in the equities market, the travel, energy. Are you - you mentioned the Troubled Company aspect of this. Are you seeing - is it lining up properly? Are you seeing spreads matching what you would expect from default risks?

DvD: Yes, absolutely. One of the things we do everyday using, what we call a bonds MRI or reduced form bond model is looking at every bond that traded in the U.S. corporate market on the previous day. And we isolate those firms that have at least two senior non-call bond issues outstanding. And meet a minimum trade volume level, which is really pretty small amount. And we then try and reconcile bond prices with default probabilities and that reconciliation has been 99% effective in understanding the drivers of bond prices.

And there are really four factors that move the price if you get to kind of the first level of transparency. One is the level of the risk free curve, obviously, where the treasury curve is. Second, the default probabilities of the issuer. And our calculations depend on financials, macro factors, and the equity price of the issuer and its history, not bond prices. And then third and fourth, the market's implied recovery rate on the bonds and a liquidity premium that is specific to the bonds of that issuer.

And so, as spreads blew out in March, what we saw two major factors driving bond prices, one was a significant drop in the recovery that people expected in the event of default. And the second was a dramatic increase in the liquidity premium embedded in the bonds price People wanted, literally more reward for relatively unchanged level of risk as measured by the default probabilities.

And that's not to say default probabilities have been unchanged. But for a pretty typical issuer, you might see one-year default probability moving up from 50 basis points to 1% towards the end of March. So that's not a huge move, and it certainly doesn't explain the majority of bond price movements. It's really lower recovery rate estimates and higher liquidity premium.

And conversely, in the improvement we've seen over April, recovery rates people expect have increased significantly, in part, because the Fed is making it clear, they're going to rescue people. And because there's more certainty about what's going to happen in a much lower liquidity premium embedded in the bonds price.

DS: Okay. Let's - so that begs the question about the role of the Fed here. And especially given your perspective that the bond market fit, there were a lot of the wages, say, the 14th percentile of, call it, the Troubled Company Index. The - what do you make of the Fed's actions so far and the Fed's willingness to step so strongly into the bond market into the fixed income sector? What do you make of that? What is your just perception of the effect that has on opportunities or on the company's issuing credit?

DvD: Well, I'm going to be very, very candid in my comments, probably won't be well received at the Federal Reserve. But for most of the last decade, we've been assured by Central Banks around the world, including the Fed, that banks are in a much stronger position now than they were in 2008. And that the kind of rescue that was necessary in the prior credit crisis will never be necessary again. And, obviously, that's - very obviously not true right now.

And so there are really two schools I thought on what's happened. One is, that the Fed has allowed a bubble in prices to take place the virus was the pin the prick the bubble. And now the Fed is seeing really the consequences of its own money printing over the last decade, particularly in the immediate aftermath of the 2008, 2010 crisis.

Another school of thought says that the risk rules that the Fed put in place the three scenarios for stress testing of Larry Summers was very candid in saying is embarrassing - embarrassingly simplistic and able to be gamed by the banks and lots of anecdotal evidence that that's exactly what they did. It allowed with only three scenarios you can negotiate with the Fed on what the scenarios are and you can fudge the numbers.

And clearly, the banks needed a rescue this time around as well. And part of the reason for that is, there's so much concentration in securities and derivatives trading now that Central Banks have allowed to happen. There's not the diversity of opinion, there's not the diversity of securities positions that in a more competitive, less concentrated market would have somebody stepped, again if bank A is panicking and bank B, C, and D are not, they provide the liquidity that prevents the volatility that we're seeing.

So a combination of simplistic regulation by the Fed and a Justice Department through both Republican and Democratic administrations that allowed a degree of concentration in the securities business that in any other industry would trigger some antitrust reaction. And that's really what the long-term solution to this hypersensitivity to risk is.

DS: Okay. That - I feel like that opens a wide area to discuss it. I don't know if it's really a field for us. But coming back to the way you approach these bonds itself and given that the Fed is what it is and Jerome Powell may not be adding you to the Board anytime soon.

What - how do you - I'm curious about how you're navigating right now? How are you, like how are you thinking about the sector? How are you dealing with default risk? We have a lot of crosscurrents. We have what the Fed is doing. We have the economic reality, which the market may not be reflecting, but seems like there's some real economic pain that's going to be felt in the coming weeks and months, if not longer.

How are you, amidst all those different things, the amount of fiscal stimulus as well, how are you sort of thinking through the - or how does your system think through this sort of scenario in this sort of - this sort of stress test as it's happening?

DvD: Well, an excellent question. And the answer actually was provided by my family doctor who called a couple of days ago to check in. And I asked her, how are you doing all this crisis, figuring that she'd be nervous about being exposed to virus patients. And instead, she said, "Oh, this is the kind of era I've lived for. I've been waiting for this, where I can really use all my skills."

And that's the same way we at, Kamakura, both with institutional clients and with retail through the Corporate Bond Investor feel about this market. And so at the retail level, we use ratio to sort out value the reward to risk. And we use slightly different analytics for the institutional market. But at the retail level, we look at the ratio between the credit spread or premium over treasuries for an issuer and divide that by the annualized default probabilities of the issuer.

So just like someone pricing a fire insurance policy, you want the premium on the policy to definitely be larger than your expected loss from a fire on that particular house and hopefully many multiples of that just in case your estimates of the probability of fire and correct.

And so, depending on the maturity of the bonds we're looking at, we're typically recommending bonds where the credit spread is 10 times, 11 times, 12 times higher than the default probabilities, and advising our retail clients to really start with the best value and work downwards, as you get full on a particular name from a diversification point of view. And there's no reason to go farther down the list when you're using that kind of ranking system for our fixed income value.

Now at the bottom of the list, who's buying the bottom of the list, let's so-called junk market. And there if the economists use the term that's called lottery demand really because of the phenomenon with lottery ticket said, millions of Americans, including my super rational late father who advise clients on investments for 50 years, but still bought $1 lottery ticket, on an average pays off only $0.70.

So why do they do that? Well, Nobel Prize winner, Daniel Kahneman wrote about this in his book Thinking Fast, Thinking Slow. The so-called lottery demand is rooted in humans' DNA. There's a real irrational preference for a huge payoff with very low probability.

And that's what you see in the junk market, a bunch of things going on in the junk market. But the primary motivation of people in that market, if they're retail, is they're paying too much for a low probability of a big return. And all of our risk measures show that clearly.

If you look at the bid-offered spreads, I was to look at Hertz (HTZ) yesterday, only two bonds traded, that were senior fixed rate bonds non-call. One had a bid-offered spread of 3 points on a $100 par value, another had a bid-offered spread at 13. And so there's no way a retail investor can get in and out of a Hertz bond when the house, so to speak, is taking such a huge chunk of your investment on day one.

So who is in a junk market? Who makes money? And again, being candid, you can just search on the phrase market manipulation and high-yield bonds. And you'll see a long list of lawsuits and transactions that, if not illegal, are - considered by most normal people as immoral like someone who has protection in the credit default swap market offers a loan to a Troubled Company, but only if the company will initiate a default on its securities because that default will trigger such a huge payoff for the person offering the loan. The payoff more than covers the proceeds of the loan they're offering.

So that's the kind of Wolf of Wall Street that's playing in the junk market. It's not - doesn't work at all for anybody A, who is honest; and B, who is a relatively small investor. The risk return ratios are just not there without that kind of tactics.

DS: Hertz is interesting as well because I haven't actually worked, but who the equity has been shockingly strong, given the bonds even were there - what I saw, they are trading quite low. They're trading in the 60s, despite this spread, something like that, correct?

DvD: Oh, they're down around 25 right now.

DS: Oh, wow. Yes. So that - I wanted to just drill down on that, when you - the way you described was 10 times the spread to - or the spread is 10 times the default risk. So that's something - literally, that's to simplify it. If there's a 2% default risk, you're looking for a spread from the risk-free of 2,000 basis points, or will go it out from you?

DvD: Let me give you some numbers from this morning's posting on the Corporate Bond Investor. What we do is list the best value names in annual maturity segments, because most of our clients are trying to basically match their forward cash needs. So they're buying a little bit at each maturity sector.

So if you're looking at one to two years, there - the Netflix bonds due in 2022, it's an issue that I own. The average credit spread is 2.77%. Our mass maturity default probability is only 0.07%. So 42 times a ratio of spreads default probability.

If you go out to 2024, there's another Netflix issue, which I do not own. There, the credit spread is 2.93. The default probability is up a little bit to 13 basis points. So you get a 22 times coverage. And then you go out, say, that 2030, 10-year-plus range, there's VMware, credit spread of 3.13, Kamakura 10-year default probability for them is 33 basis points. So a little under 10 times coverage. It typically get a little lower coverage as you go way out on the maturity spectrum.

And so that that's the way we do the rankings. And our number one company on the very short end right now, which is nine months and under is a 2023 issue from a very exotic issuer, it's Indonesian coal mining company called Bayan Resources. And that's got a ratio of credit spread to default probability. That's just off the charts. It's over 100 times.

And part of the reason is, nobody likes energy. Part of the reason is, not that many people like Indonesia. And so the combination of those two factors gets you a huge premium. But we strongly recommend with that kind of exotic issuer, that our ranking is the starting point that helps guide people where to do their own due diligence.

We don't recommend ignoring due diligence relying on any third-party. You have to do your own homework. And so, particularly without that name, that's essential. But if you do that due diligence and you're happy with what you see, the reward to risk ratio is too spectacular.

DS: Okay, very interesting. So, Bayan Coal was the name?

DvD: Bayan Resources.

DS: Bayan Resources.

DvD: And the ticker, which is the Indonesian market ticker is BYAN.

DS: Got it.

DvD: Now, some of these non-U.S. issuer bonds are - have restricted access in the retail market. So I haven't checked this one, but I haven't heard any problems buying it from our client base so far.

DS: Got it. Okay, very interesting. So I guess that you've already kind of given us and it's interesting to think about Netflix because it's still considered sort of a glitzy stock, but to hear that the bonds are relatively attractive in the way you look at it. But any other bonds that stand out right now or bonds that you think are interesting?

DvD: Well, let me go to kind of the longer maturities where the list is a little bit different. And so I'm going to look at our rankings for 20 years and out. And number one on the list is Thomson Reuters issue due 2043. The spread is 2.62%. Our match maturity default probability is point 0.26%. So literally, 10 times ratio.

And then number three on the list, Danaher, with a ticker symbol DHR, is 8.38 times ratio. I own the Biogen 2045s. Today, the 2050s are in the ratio of 8.33 spread to default probability ratio. And then a longtime favorite of mine, it's been near the top of the list almost every day for the last six years is Southern Copper Corporation (SCCO), the 2045, sorry, eight times ratio, and the same is true for the 2042s.

And then even though we're a competitor of S&P, that won't stop me from saying their bonds due 2049, are showing a seven times ratio, credit spread at 1.54, default probability of 0.21. And so that's worth a good look as well.

And then finally, a little farther down the list, Amgen 2051. So if you're in your 30s or 40s, and you're starting to hedge your post 65 cash flow, that's a good one, 1.75% of credit spread, 26 basis point default probabilities, it's almost seven times ratio.

Now, one of the things I should add is both institutional and retail clients often say, "Well I need yield." And I understand why people say that, but they're only looking at half of their assets and liabilities. They're looking at their assets and ignoring their liabilities. When you're 65, if you retire, you're going to need X dollars per year.

So you already have a liability at that maturity. What you need to do is lock in income and cash flow that more than covers your need. And so you'll be hedged with respect to interest rates. You've got cash ins and cash outs that have the right relationship to each other.

But typically, people ignore the fact they've already got the liability there, the cash need and try and maximize yield. And when you do that, you're going way down the reward to risk ratio and actually cutting off your nose, despite your face. And so I tell people, if I need more yield than I can get in the marketplace, I'm not going to go down. I'm not going to go down our risk ranking. I'm either going to get a second job, cut my expenses, or if that doesn't work, buy lottery tickets. It's a fair game than trading junk bonds, that's for sure.

DS: Well, I think that's good.

DvD: I'm joking, obviously, after what President Trump went through on sarcasm, that was a sarcastic joke. I wouldn't recommend anybody buy lottery tickets. But you can do better with treasuries.

DS: Well, that's - that is - I've got to the clarification and I think that's - obviously, it's a good reminder of how to think, I think, it's, I would say, for myself, for people on Seeking Alpha, you get a little bit lost in the game of this and trying to maximize returns and forget the real-world goals that are behind all this and that are more important than whether or not you beat the market or get the max get lucky, whatever else. And so I think that's a very helpful place to hit.

DvD: Well, I look at two investors with regard to be in the market. One, obviously, is Warren Buffett, whom everybody follows. And the other was my father, who again, was an investment manager for 50 years. And he had tremendous success, "beating the market", as Warren Buffett did early in his career.

After my father passed away, my brother who was also working at the same firm called me up and said, guess what our father had in his investment portfolio. And I said, "Surprised me." And he said, "Well, he was way overweighted in the recreational vehicle market because he loved RVs."

And that's exactly Daniel Kahneman in the story from Thinking Fast and Slow, where an investment manager bought Ford's stock because he loved Ford cars instead of - because Ford common stock was at a price that was good value. And so just remaining as dispassionate as possible and remembering why you're investing because you've got cast needs down the road, is critical to everyone's success.

DS: Yes, that's a great reminder, though, of course. Avoid lottery tickets and be dispassionate in prioritizing what you need for the long-term. And given what's going on in the bond sector, it's just worth finding the right ratios and the right risk rewards seem like that?

DvD: Exactly. And one more thing, especially after what we've been through the last two months or so, is recognizing there going to be some surprises along the way. And even though you've done the best job possible for forecasting your liabilities and future cash needs, you might be wrong.

That happened to me six weeks ago, when my daughter called up and said, "Dad, good news, bad news: A, I've been accepted to a medical school; B, they're giving me loans and not scholarships." And so all of a sudden, my future cash outs dramatically increased more - by more than I expected. And so that's good news net-net. So you're constantly making incremental changes on both your liability forecast and the cash flows you're trying to generate on the asset side.

DS: Which is where safety becomes so valuable because it then affords more flexibility when you need it?

DvD: Absolutely, right.

DS: So, okay. Well, great. I've been speaking with Donald van Deventer, who Founder of Kamakura, and as well the author of Corporate Bond Investor. You can check that out on Seeking Alpha's Marketplace. Donald, thank you so much for your time today. I really enjoyed this and all the best.

DvD: Daniel, it was great to chat. And anytime you want to talk about classical guitar playing, let's compare notes on how we can both break out of beginner mode.

DS: Absolutely. Well, that'll be the next Zoom session. We'll take questions together.

DvD: I'm sure in the customer base of Seeking Alpha, there are many brilliant guitarists and maybe they can educate you.

DS: Yes, please find us. You know where to find us at Seeking Alpha placed in.

DvD: All right. Thank you very much, Daniel.

DS: Thank you so much, Donald. Take care.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Donald van Deventer is long the Netflix bonds mentioned in the video. Daniel Shvartsman has no positions in any stocks/bonds mentioned. Nothing on this video should be taken as investment advice.