The Insight: Conversations - Oaktree Conference 2024 Edition

0:05Hello, and welcome to the Insight by Oaktree Capital. I'm Anna Shemansky, Oaktree's senior financial writer, and today we have something a little bit different for you. We've put together three excerpts from Oaktree's recent client conference. First up, we have co-chairman Howard Marks, who will set the stage with his discussion about the massive changes we've been seeing in financial markets in recent years. We'll then hear from members of Oaktree's global credit team who will explain how these changes are impacting performing credit. And finally, you'll hear from Oaktree's Global Opportunities team.

0:39We'll discuss today's restructuring landscape. So with that, I'll turn it over to Howard.

0:48Back in October of 22, Bruce and I resumed our post-pandemic international travel with a trip to see clients in the Middle East, which we obviously hadn't been to in a couple of years. We didn't rehearse what we were going to say, but when we sat down and started to talk about the investment environment, we quickly converged on our thoughts in agreement, which morphed or gelled into something I call sea change. And many of you may be familiar with the sea change thesis, but I think it's so important that I'd like to review it with you again. A sea change, of course, is a change that is fundamental, significant and potentially long lasting, not your normal garden variety, short term fluctuation.

1:31And as I said in Further Thoughts, largely thanks to highly accommodative monetary policy, we went through an unusually easy time in a number of important regards over a prolonged period, but that time is over. And that is our belief, and we believe at Oak Tree that we are in a fundamentally different environment. And it's such an important change that I think it's very key that we and you recognize it and act accordingly. As I said in the first sea change memo, in 1980, I had a personal loan outstanding from a bank and the interest rate was 22 and a quarter 40 years later in 2020 I was able to borrow at two and a quarter fixed for 15 years and I promise you I did so I believe that the 2000 basis point decline over that period was the most important single financial event of the last half century not the bankruptcy of Lehman not the meltdown of the tech bubble or Black Monday.

2:27This was really important, but I think few people recognize it as such because it took so long and occurred so gradually. 2 ,000 basis point decline in rates. I believe that a significant amount of money that was made over that period was because of the tailwind provided by the massive drop in interest rates. Declining interest rates have a number of very salutary effects. They stimulate the economy. They increase consumer demand by making time purchases cheaper. Thus, they make most businesses more profitable. They make assets more valuable by reducing the discount rate that is applied to future cash flows.

3:07They reduce the cost of capital and make financing more accessible. And they make default and bankruptcy less likely. And from 2010, And for example, to 2019, we had a default rate on high yield bonds that averaged 1 % a year, whereas the historic average is close to 4%. So very, very profound impact. I have likened this, and maybe it's because Bruce and I came up with the idea while we were traveling, to the moving walkway at the airport. You get on the moving walkway, you walk at your normal pace, you make wonderful progress, and you say, boy, I'm fit. And I think investors did the same. and they made a lot of money, thanks largely to the declining interest rates, and they say, boy, I'm smart.

3:52But I think that the impact of the moving walkway is subtle, so the reason for the progress can be overlooked. I don't think it should be. Now, the memo focuses on the period from 2009, at the beginning of which the Fed took the Fed funds rate to zero for the first time in history to fight the global financial crisis, to the end of 21, when it gave up on inflation being transitory and decided to raise interest rates, which it did in early 22. Now, when I did the research, I was surprised to find that over this 13-year period, I think the Fed funds rate averaged about a half a percent, which is extremely low.

4:31The result was the longest economic recovery in U.S. history, exceeding 10 years, and the longest bull market in the S &P in history, also exceeding 10 years. It was a great time for asset owners, a great time for investors who bought assets using borrowed money. They got a double bonanza since the cost of capital went down at the same time that assets were appreciating. But the period was correspondingly challenging for lenders, savers, and bargain hunters. Bargain hunters because in that salutary period, there was no impetus, no urgency to sell. And it's from that impetus that the bargain hunters get their bargains.

5:08So investors in fixed income or credit or debt, whatever you want to call it, struggled in what I call a low return world. There are also some problematic side effects. The memo I put out in January entitled Easy Money was actually inspired by an English financial historian named Edward Chancellor and a book he wrote called The Price of Time. That's really what interest rates are. They're the price of time. I lend you my money for a period of time, the price you pay me is the interest rate. And the book points out that there are problematic side effects. Low and declining interest rates reduce the perceived opportunity costs, so people are eager to do things they otherwise may not be, and to make investments they otherwise may not be.

5:49That encourages risk-taking and leads to unwise investments. And my favorite word in the book was attributed to the Austrian economist Hayek, who used the word malinvestment. And I think it's a great word. It's unwise investment. Low rates enable deals to be financed readily and cheaply. They encourage the use of leverage and that increases fragility of transactions and it induces optimistic behavior that lays the groundwork for the next crisis. Now there's a regular cycle in these events that I've seen over my career. In this case it took a long time to play out. But first, you have stimulative rate cuts that bring on easy money and positive market developments.

6:31We see that dating back to 2009. This reduces the prospective returns on asset classes as the capital market line shifts downward. This leads to an increased willingness to bear risk. This results in unwise decisions and eventually investment losses, which brings on a period of fear, stringency, tight money, and economic contraction, which leads to stimulative rate cuts. So this is the nature of cycles, rise and fall. Each cycle is linked to the next. As the Manchester banker John Mills commented, according to Edward Chancellor in the book, I love this quote in particular. This is the greatest quote from the book.

7:06As a rule, panics do not destroy capital. They merely reveal the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works. In other words, in the easy money period, when the standards for investment are low and unwise decisions are made, we have malinvestment. That's the destruction. It is disclosed in a later period. But the destruction dates from the mistaken investments. And of course, that's what Buffett was saying when he said, you don't find out who's been swimming naked until the tide goes out. The tide goes out during panics, and it discloses the naked investments that were made in good times.

7:47And by the way, lenders have a saying, an old saying, that the worst of loans are made in the best of times. And that's what this is about. Anybody who came into the investment business after 1980 had, until 22, essentially seen only declining interest rates or ultra-low interest rates or both. And there's a tendency when something is the case for some years to think that's normalcy. And especially when it's the case for 42 years. They say, well, declining and low interest rates are the norm. And so we can, for example, make leveraged investments and invest at today's low rates, and they will supercharge the returns.

8:24Well, that doesn't answer the question of what happens when rates fail to stay low. And in the case of interest rates, I believe it's not the case that what we saw in those 40 years is going to remain the case. In 21, we began to see that continuous monetary stimulus can have negative consequences. The massive COVID relief measures and the supply chain snags meant that too much money was chasing too few goods. That's the classic definition of inflation. As a result, inflation rose in 21 and persisted into 22, forcing the Fed to acknowledge that it wasn't transitory and to discontinue its accommodative stance.

9:01And the Fed raised interest rates dramatically. Eventually, it caught up with the inflation rate and started to bring the inflation rate down. and it has done so with good success. So we think that if the easy money period is over, there may be a number of consequences. We think economic growth may be slower, profit margins may erode, investor psychology may not be as uniformly positive as it was in the period of declining rates. Ownership interest may not appreciate as reliably, you know, declining rates cause an asset bubble and we've had one. The cost of borrowing will not trend down consistently Leverage is unlikely to add as much to returns as it did in that salutary period.

9:46Businesses may not find it as easy or inexpensive to attain financing, and default rates may head higher. And we believe strongly that these things are the case, especially the latter six, which are more investment characteristics than economics. So here's the current consensus of thought. Inflation is moving in the right direction and will soon reach or be near and headed to the target of the Fed of 2%. As a consequence, additional rate hikes won't be necessary. As a further consequence, we'll have a soft landing marked by a minor recession or no recession at all, something that a year and a half ago was considered virtually impossible.

10:28The Fed will be able to take rates back down. This will be good for the economy and the stock market. And I agree with most or all of the above, but not with the extent of the consensus's optimism with regard to timing and extent. Back in December, the consensus of investors would be that there would be six cuts this year. Interestingly, the dot plot of Fed executives thinking was that there would be three. And the investors said, no, Fed, you're wrong. You're going to cut rates six times. Now it doesn't think that anymore. And now the thinking is two to three. As a result of the cuts that will begin later this year, I think, within two to three years, the Fed funds rate will decline to the region of three, three and a half or so and settle there for the subsequent years.

11:14And I think three to three and a half will be roughly the norm in the coming years. That's lower than today's five and a quarter, five and a half, but very different from the 09 to 21 period. And that's the most important message. Nobody can predict these things with any precision at all. But I think directionally, that's the way we should all be thinking. Now, Einstein defined insanity as doing the same thing over and over again and expecting a different result. But I think it's equally insane to do the same thing in a different environment and expect the same result. And if the coming environment is going to be different, as we believe, I think that the things that succeeded best in the period of low and declining rates will not succeed as well in the coming years.

12:04Now, you have to understand the impact of the new environment under different strategies. And I believe strongly that the ones that did best will not do best in the years ahead. Most investment strategies employing leverage were invented since 1980. That is to say, they were invented in the period of low rates. It shouldn't be surprising that leverage strategies performed well in the period of low rates, but I think they're unlikely to be equally successful in the years ahead. That was a great period for investors and borrowers. This, I think, will be less good for them and a better period for lenders.

12:41So the point is that today, liquid credit instruments and private credit instruments are offering yields in the high single digits or in the case of private, in the low double digits. And these yields are number one, highly competitive with the historic return on equities, which has made people so happy. The S &P has returned about 10 % a year for the last century on average. These returns exceed most investors' required returns and these returns can be earned with greater certainty and less risk of disappointment. So the bottom line for me, as I say here in quoting from the sea change, is that it should follow that the investment strategies that work best over the declining rate periods may not be the ones that outperform in the years ahead.

13:28The economist Paul Samuelson, who wrote the textbook I learned from in college, and most of us did, said, when events change, I change my mind. What do you do? The investment environment has changed radically. What will you do about it? Or to play devil's advocate, what could be the reason for not significantly increasing the allocation to credit? That would be an important thing today. For our second segment, we have an excerpt from a panel discussion about finding relative value today. The moderators of the panel are Danielle Polly, Assistant Portfolio Manager of Oaktree's Global Credit Strategy, and Bruce Karsh, Oaktree's CIO and co-chairman.

14:10You'll also hear from David Rosenberg, Oaktree's head of liquid credit, and Madeline Jones, portfolio manager of Oaktree's European senior loan and European high-yield bond strategies. We hope you enjoy the discussion. Thanks to all for joining us today and what we hope is going to be an engaging relative value debate. I'm Danielle Pawley, Assistant Portfolio Manager of our Global Credit Strategy, and I have the privilege today of co-moderating our discussion with Bruce Karsh, Oak Tree's co-founder and CIO, as well as Portfolio Manager for Global Credit and our Opportunistic Credit Strategies.

14:49So I'll kick off the discussion today with a favorite question that Bruce and I like to ask, which is, if you have an incremental dollar, where are you spending it today? And so, David, I want to start with you. If you have that dollar in high yield, what are you buying? Sure. So if you think about the world today, the key here with the sea change in rates is you don't have to take a ton of risk to get a good yield. And so for me, when I look at high yield, I like going to a single B bond right now. If I can get an 8 % yield there, I don't feel the need to be a hero and reach for risk right now.

15:21I like to sit and kind of grind out the coupon. You didn't mention spread. Those are pretty tight today. That's true. And it's an important question. I think we get this debate a lot. Would you have good yield, bad spread? What does that mean? And what I remind people all the time is when you think about spread, spread is important if you need total return. That's the math. If you want total return, you have to have spread compression. And I think for a long time, we went through a decade of nearly zero rates. And when rates are very low, the yield and high yield was four or 5%. So you needed total return to justify taking the risk.

15:53And so I think people have been programmed that you wait for spreads to go wide and you jump in. The reality is at 8 % yield, I don't need a total return. 8 % is good enough. I was talking with a strategist the other day who reminded me it's the high yield market, not the high spread market. The message there is that you're going into this asset category to earn income. And right now, if things just stay where they are and you can do a good job staying out of trouble, you're going to earn a pretty good income. You don't have to look for things with widespread that will be riskier and push for a total return.

16:26Well, first of all, what kind of default rate do you see right now in the current economic environment and what kind of default rate do you see in some kind of downturn? In a downturn. Bruce, it's a great question. I always tell people who care for what you wish for. The market's been so focused on a pivot. Think about what the world has to look like if you see 100 basis points dropping rates and it's not a pretty picture. So right now, the quality in the high yield market is quite good. This is the best quality we've seen in a decade because because when COVID hit, you had all these fallen angels fall into high yield.

16:56So over half the market is double B rated and all the weak triple C's defaulted, fell out of the market and we had a 7 % default rate in 2020. And so with that cohort right now, my expectation is, you know, you see a two to 3 % default rate. And remember that's a jump from where we were, which is near zero, but the 30 year average is three and a half, four. And so it's not too scary. Now, if we actually are in an environment where we're getting three, four rate cuts, then that means that default rates are more likely in the 4 % or 5 % range, in my opinion. So I do think within high yield, there is going to be a cohort of names.

17:32Madeline, I'm sure we'll talk about it in loans as well, where there's a lot of leverage on some of these companies. As they go to refinance, there's going to be a struggle for some of these balance sheets. We've made a point of avoiding those, in our opinion. But I do think in the end of the day, if the consumer does start to slow down and the economy does start to slow down, you're going to see EBITDA start to waver. You mentioned loans, which Madeline covers. I think it's a good opportunity to compare and contrast the two right now. I mean, what are you seeing? Can you buy something more attractive than David can?

18:03Yeah, I think very similar to David. We're not looking to stretch the boundaries of risk here. We're looking for nice quality single B senior loan, senior secured. loans. And these are mainly sourced today from a very active primary market. Primary market is giving us lots to do. A lot of it is existing loans which are extending the maturities of existing debt. But these are loans which are coming to the market with a full knowledge we're in a high rate environment. And these are freshly underwritten with a view that they can tolerate higher rates. So buying that kind of credit quality where we can see the cash flow generated by the company can well support and handle that kind of underlying rate rise that we've seen.

18:46But the sort of spreads we're getting in loans are really interesting now on a relative basis. And I think versus other credit classes where we've seen spread compression in loans, our spreads are still above average, still above historical average. So why is that? Why are spreads still so attractive? The rest of the market, there's been a flood of money into credit, spreads have been tightening, and yet not so. Is it a signal that there are some issues, problems, quality-wise, in your market? Well, I think the loan market and investors like ourselves have done a good job of dissecting the problem area of the market, and that's the sort of loans that are trading in the 80 cents, 70 cents and below on the dollar.

19:30That's not the new deal. The new primary deal, which is very well structured with a thicker equity tranche underneath us, That doesn't answer that question. Why is that relatively wide? And I think it comes back to who's the main buyer of loans? The main buyer is the CLO. The CLO mechanism works in that you're taking the loan assets, you're securitizing that with debt, and you need to get paid an average 200 basis points more than the amount you're paying on those liabilities. And say average price of CLO debt at the moment, the debt stack is 230 basis points, you need to be paid 425, 430 to get that economic mechanism to work.

20:14If it starts to come in tighter, portfolios, CLOs, CLO rampers are not going to buy anymore. They stop buying and that eventually has to widen out again to attract the audience. What about quality? Bruce had asked me about defaults and default expectations. Yeah. Has your default expectation changed recently, and where do you see that for loans? The loan market has been pinpointed as some kind of wild west of defaults, and I think hopefully we're past some of that negative press, which we saw maybe two or three years ago. There's the junk loan market. Yeah. And some of the statistics were, to my mind, extraordinarily unrealistic for the loan market.

20:56I think the loan market, well, defaults come either two ways, right? Right. running out of cash as a company, or you hit your maturity and you can't refinance it. Now, there were very, very few loans who were so over-levered they ran out of cash, but it did happen. And again, those have been isolated and that risk has been exposed. We're going to stay well away from that kind of risk. There are some there. But then there's the other side. They've run out of runway and they've hit their maturity wall. But for most of the loan market, these are good companies. They perform well. They've got good management teams.

21:31So when it comes to the end of that maturity, as we're seeing today, loan managers like ourselves are happy to extend that maturity out. Now, I think there is still a cohort in the loan market that are stretched, and they will need to restructure. What about private debt and the impact on that cohort that's struggling to refine because of the growth there? Yeah. Thank you for raising that one, I think there's another reason why I think default rates have really surprised to be much more modest. When I think about the loan market prior to the global financial crisis, there were lots of small companies coming to the loan market.

22:09Our portfolios had companies of EBITDAs of 100 million. Average EBITDA in our portfolio now, 900 million. Big companies, diversified risk, they can handle more leverage. And now with the advent of the private debt market, those smaller companies have gone to a better place, better structure, lower leverage, the more appropriate capital structure. And they've left the loan market. And I think that has improved quality, but it's also meant there's a new capital provider out there. So for credits which do need a structural solution, not just private lending, but other parts of oak trees, special situations, capital there that can come up with a creative way to provide that liquidity or delever the structure, that's hugely valuable for our market.

22:56What about the issue that there haven't been covenants for years in these loan indentures, and you're starting to see sponsors in particular, but even companies, take out rescue loans that become leapfrog structurally existing first lien. So the first lien that you think is first lien ends up becoming second lien in a way. What do you see in terms of that trend? Also, you may want to touch on credit on credit. violence. Well, I'd rather not, but since you ask. You can't get around the fact that over the years, investor documentation and protection in the loan market has been eroded. And I think that's the reality of the deals that have been done in the 2021-22 era.

23:46And you're starting to see the reveal of that when it comes to the restructurings, that lenders have less protection to defend themselves with. Now, I think last year, the average recovery on loans was 50 cents on the dollar. And you can tell from that, that's below what we used to get 70 cents or so, 60, 70. So there has been erosion that has been crystallized into a less good recovery. So I don't think you can avoid that reality. But that's again why I like the primary market, because the primary market is starting to close down some of those aggressive loopholes. Also, I think lenders are getting a bit smarter at defending themselves and not being picked off and not being forced into lender-on-lender violence to recover.

24:31I think there is more cohesive cooperation agreements. We always learn a little bit more from the bad times of the past to defend themselves. You're an expert in European senior loans, and you also know a fair amount about U.S. senior loans. Is there a difference in those markets? Do you favor one versus the other? There's two things. I think we could go back to the rate environment, I mean, I think being floating rate, you have to think about whether Europe may cut rates before the US. That's the economic side of that equation. I also do think European documentation is a little bit better when it comes to recoveries.

25:08I think the jurisdictions, they're complex, so one region to another can vary quite significantly. but some more into creditor control, criminal liabilities of directors when they're forcing you into restructuring. Things like this just make it much more complicated to affect some of the aggressive restructurings that we've seen. And just to go back to the question just for a second on lender and lender violence, because it's true across all credit, right? You know, there's a lot of secured bonds in the market as well that now can get primed and find themselves in second versus first. I honestly think this is where credit picking is going to matter again We've been through a pretty long period where the credit picker is very frustrating because you'd say hey, you know Being good at credit is really the key and people say well I have a Fed put and credit doesn't matter and it was true for a while the Fed put would bail everybody out I think we're past that now and it's going to matter if you went into a credit where the balance sheets broken you're likely going to go through a period where somebody's going to extract value from you to try and fix this company.

26:10But if you did a good job avoiding those companies, you're getting a very good yield and you're going to be fine. And so I think that's going to separate the herd today because of the likeliness that we're going to start seeing more and more of those type of deals. We've heard about performing credit. So now we're going to look at opportunistic credit in an excerpt from a panel discussion on today's restructuring environment. The discussion was moderated by Oaktree co-CEO, Bob O 'Leary. And it also features comments from Brooke Hinchman, head of North America for Oak Tree's Global Opportunity Strategy, Jared Parker, co-head of North America for the Global Opportunity Strategy, and Ross Rosenfeld, managing director with the strategy who focuses on legal matters related to restructurings.