Howard Marks: bonds are back in fashion

By Mina Kimes, writer May 10, 2010: 5:46 PM ET

Fortune) -- Since founding Oaktree Capital in L.A. in 1995, Howard Marks, 64, has built his institutional investment firm into a $76 billion powerhouse in high-yield bonds, distressed debt, and private equity. During the 2008 financial crisis he raised an unprecedented $10.9 billion fund to buy distressed assets -- a bet that has paid off richly for his investors. Admired for the folksy charm and astute commentary of his letters to investors, Marks shared his wisdom with Fortune's Mina Kimes.

Edited excerpts are below in an extended Q&A from Fortune magazine:

You mostly avoid the mainstream stock and bond markets. Why?

We try to participate in asset classes that not everybody knows about, not everybody understands, and not everybody feels good about. Assets that some people find controversial or unseemly or scary. Assets where not everybody has the same information. If everybody knows about a market, has all the information, feels good, finds it uncontroversial, and is willing to go there, why should it be particularly attractive? That's why we don't do anything in the mainstream bond market or big name stock market. If you're going to outperform, you need an edge.

Some say the last two years were the buying opportunity of a lifetime for vulture investors. Are you still finding opportunities in distressed debt?

The biggest opportunities we found were in the excess of the buyout industry. Record amounts of equity capital flowed to buyout funds. Then they could take that capital and avail themselves of leverage very easily, with weak terms and low costs. That permitted them to buy great companies -- possibly the best companies that have ever been bought out -- but at high prices with high leverage. So when the assumptions that underlay those transactions weren't born out, you saw real disappointment. Companies had taken on debt they couldn't service. That's when we ramped up our activity.

That's still where we're looking, but there has been a very substantial recovery in the credit markets. You can't argue that things are as cheap as they used to be.

So the greatest opportunities have passed, and aren't likely to return anytime soon?

I think opportunities like this last one will recur, though probably not to the same extent and probably not for the same reason. Since we started doing this in the 1980s, this was our third episode like this. And there will be more, because people go to excess. It's the excessive booms that lead to the busts, and it's the busts that give us an opportunity to buy -- I don't think that will ever change.

You're an expert at taking advantage of market inefficiency. What mistakes do you see investors making now?

The biggest mistake is that the prices of many assets in our world -- i.e. the credit markets -- are back to 2007 levels. The prices assume a decent economic recovery. But if the recovery turns out to not be decent, there will be disappointments. John Kenneth Galbraith said there are two kinds of forecasters: the ones who don't know and the ones who don't know they don't know. I put myself in the former category. We don't have an economic forecast. But we're not counting on a high degree of prosperity in the years that lay immediately ahead.

So would you describe yourself as bearish?

No, not bearish. Bearish sounds like an emotion. I see things to worry about, but I always see things to worry about. I'm not a perma-bear.

What worries you?

Number one, that the economy is highly reliant on the government stimulus programs. What happens when they're withdrawn? Number two, the economy is reliant on artificially low interest rates. What happens when they rise to normal levels? Number three, there are still a lot of problems to be worked out in commercial real estate, and a lot of banks still hold a lot of commercial mortgages. Number four, the main source of energy in the economy over the prior twenty years has been the consumer, who did his part by spending more money than he made. Where does growth come from in the next five years if the consumer doesn't go back to doing so?

How big of a problem is commercial real estate?

I believe that something like 60% of all commercial properties changed hands at the top of the bubble, in late 2006 and early 2007. Let's say the average capitalization rate was 5%. That means the price was 20 times the net operating income. Today, net operating income is down and people won't pay 20 times that any more; maybe they'll pay 12 times. So the value of the building is cut in half, and it still has the same mortgage.

A lot of banks have mortgages on their books that they're going to lose money on. That's the main reason why the FDIC will see a few hundred more banks go under this year. I think real estate is far from being out of the woods.

High yield bonds have run up some 50% since the market bottomed. Has that ship sailed?

It doesn't take a brain surgeon to see we've gotten most of the returns. You're not going to have that again. The question is, are they fairly priced, overpriced, or underpriced? At this point, probably fairly.

So is it a matter of selectivity?

Selectivity is very important today. If you think about the virtues of an investment manager, what are they? Discipline, patience, selectivity, discernment. That's what you need going forward. You didn't need that last year, when things like discernment and selectivity held you back. You needed capital to invest and guts. Capital and guts are not the answer in 2010 and 2011. The biggest mistake you can make is to not notice that.

What advice would you give to the average investor right now?

You made a lot of money in 2009 and the first quarter of 2010. Now is the time to take stock. The people who were able to take on risk last year did very well. Now, most people have joined the party. You're not going to have incremental buying pushing prices up dramatically. The markets had a good first quarter, but not at the clip of 2009. So things have leveled out. Prices on most assets are roughly fair. Fear and greed are in balance today. Now is the time to assess where you really should be -- not where the government wants you to be, or where interest rates require you to be, but what's good for you based on a longer view.

Speaking of rebalancing, investors have been flooding bond funds for more than a year now. Given the probability of rising interest rates, are we looking at a bubble?

Market behavior is best understood as a pendulum. It's like hemlines: They go up and down, because that's all they can do. Things go in and out of fashion, and bonds are back in fashion.
0:00 /4:59Bank regulation is probably wrong

What happened? We had the post-bubble collapse in 2000 and the crisis in 2008, and stocks didn't do so well, and bonds did better. Money has run into bonds, so their prices are up, and their yields are down. The other thing that's brought down bond yields is the fact that the interest rates on treasuries are so low. So today, even though there's a healthy spread between high yield bonds and treasuries, the absolute yield on high yield bonds is quite moderate. So interest rates are low, and bond yields have a long way to go on the upside, and not that far on the downside. The question of whether interest rates will go down or up in the near future isn't easy. But it's important to be conscious of the possibility that they'll rise.

Oaktree runs the Vanguard Convertible Securities fund, which is up nearly 40% over the last year. Are convertibles still a good bet?

I like to call convertibles 'equities with training wheels,' because they tend to reflect about two-thirds of the market's gain, and in the bad times do better. I don't sit around and say what I think the stock market is going to return, but I do think convertibles are a good way to invest when the outlook is uncertain. And I think the outlook is always uncertain.

What's your outlook for private equity?

Private equity -- by which I mean buyouts -- is historically reliant on financing. There's billions of dollars of equity capital in buyout funds today. That would normally require hundreds of billions of dollars in borrowings for leverage. I don't think that's available right now. I think that the buyout firms are going to have to be more resourceful. They can't just find a company, put in a little money, and borrow the rest. The former business model was pro-cyclical. It said you invest the most when you can borrow the most, and you borrow the most when the market is at its highs. But at the lows is when you should be buying.

Many hedge funds suffered huge outflows during the crisis. Will investors come back?

One of the things we learned about hedge funds during the crisis was that their open-endedness was a liability -- some were constrained from buying at the lows because they had to worry about outflows. They say cash is flowing back in. I would imagine that some managers are going to go for longer lock-ups this time, if they can get them.

Someone once said hedge funds are a compensation scheme masquerading as an asset class. I've had guys come to me and say, we're putting together a fund of hedge funds, and I've asked them outright, "What is a hedge fund?" They looked at each other and didn't say a word. On average, why should hedge funds outperform anybody else? People say that smart investors are attracted to the 2 and 20 fees, but even dumb people are attracted to 2 and 20 fees. There's nothing special about hedge funds -- just hedge funds run by special managers.

You've long touted the importance of risk management. After the financial crisis, do you think Wall Street will change its ways?

Well it should, shouldn't it? One of the big lessons of the crisis was that people didn't worry enough. They weren't conscious of risk, and they didn't behave in a sufficiently cautious manner. You would think that the crisis would show people the errors of their ways. But it didn't last long enough for people's behavior to be lastingly changed. There's already some pro-risk behavior coming back.

When the government drops the rate of T-bills to 0.25%, it basically forces people to take more risk. The ultimate safe investment doesn't return anything anymore, so if you want to make any decent money you have to make riskier investments. That's one of the upshots of this government policy on rates.

How would you grade the government's handling of the crisis?

I think that the government did a lot of things that were very important and got most of them right. What would have happened if the government had not guaranteed commercial paper, money market funds, and bank borrowings, and had not pumped in liquidity? I think that extreme actions were called for, and I think that extreme actions were taken -- mostly correctly. This wasn't a test where the smartest kid in the class could get a 100. It was one where the smartest kid got a 70. Our leaders may have gotten something close to 70, which, on that curve, is an A.

What are your thoughts on financial regulation?

It's a very mixed picture. On one hand, it's clear that a lot of institutions made a lot of mistakes. It's not clear that regulation would have prevented that. The most regulated institutions -- the banks -- made the biggest mistakes. And what about hedge funds, which are unregulated? They had the fewest problems. To say that, if we just had more regulation, we'd solve these problems, you'd have to be knee-jerk pro-government. And I hope I'm not a knee-jerk anything.

On the other hand, I do think there were obviously regulatory failures, and there are probably ways in which regulation can be strengthened. But I don't think it can be strengthened to the point where it solves the problem, which is booms and busts. We'll always have cycles, because that's human nature.



From Money CNN

The end of the treasury bull run

By Paul J. Lim, senior editor


(Money Magazine) -- Making money in bonds used to be so simple: All you had to do was put your dough into U.S. Treasuries and watch it rise.


Had you held your entire portfolio in U.S. government issues -- which have a minuscule chance of default because they're backed by the full faith and credit of Uncle Sam -- you'd have earned an annualized return of 8.5% over the past two decades. That's about half a percentage point a year ahead of the stock market and three points above their historical average.

Alas, "as far as Treasuries go, the good times are over," says Mario DeRose, fixed-income strategist for the brokerage Edward Jones.

That's because several unprecedented economic developments that fueled the bond boom are on the verge of reversing course. They include the precipitous decline in inflation (from double digits in the early 80s to virtually nil today) and the sharp drop in market interest rates (which sent yields of 10-year Treasury securities from more than 15% in 1981 to below 2.2% in early 2009).



Those lower yields caused the prices of older, long-term bonds that pay higher rates to shoot up in the open market. Meanwhile, when the stock market went bust, investors around the world began fleeing to Treasury bonds as a safe haven. So much so, in fact, that Warren Buffett warned a year ago that a bubble was forming.


He called it, all right. As rates began to rise in 2009 -- thanks in part to an improving economy and growing inflation fears -- long-term government bond funds took it on the chin. They fell nearly 12% between the start of the year and mid-November.

Is this the start of a bear market in Treasuries? "It's certainly possible," says Peng Chen, president of the investment consulting firm Ibbotson Associates, "especially if inflation rises and the Federal Reserve has to raise interest rates aggressively to combat it."

All this may have you scrambling to figure out what, if anything, to do with Treasuries you currently hold -- and with your entire fixed-income portfolio, given that the same trends hitting Treasuries affect other bonds too.

Here are three smart strategies for the fixed-income holdings of three kinds of investors: those who can't stand the idea of losing a cent; those who are willing to take on more risk for a higher potential return; and those who fall somewhere in between.


Option 1: If you can't tolerate losing any principal

Stick with the feds, but do it the right way

A 100% U.S. Treasury strategy does away with credit risk: the possibility that the issuer won't be able to pay you back. But you still face the possibility that rates will rise, reducing your bonds' value in the open market. If you want to stick with U.S. government issues, make some changes to minimize that risk.

First, pare back on long-term exposure. Bonds that mature in seven or more years are more vulnerable to price swings than those maturing in less than three years.

Keep a portion of your Treasury holdings in individual issues, not funds. As long as you hold your bonds to maturity -- at which point the government will redeem your principal -- it won't matter if their value fluctuates in the meantime.

Ladder the bonds, splitting your money evenly among one-year, two-year, three-year, five-year, and seven-year securities. When your one-year T-bill matures, use that money to buy a new seven-year note. And so on. That way you'll never invest all your money when rates are lowest.

Put another slice into Treasury inflation-protected securities (TIPS). Yes, their market price could fall if rates rise. But these bonds offer peace of mind that regular Treasuries do not: Their principal value will at least keep pace with inflation. At today's yields you'll do better in TIPS than in Treasuries with the same maturity as long as inflation exceeds around 2% annually over the next decade -- a reasonably safe bet.

Finally, to add a little yield, put 10% into U.S. agency debt such as Ginnie Maes -- mortgage bonds tied to the Government National Mortgage Association, a federal agency. They're fully backed by the feds, yet give you a yield boost of about one percentage point over Treasuries.

An easy way to invest is via the Vanguard GNMA (VFIJX) fund (recent yield: 4.2%), which invests not only in Ginnie Maes but also in bonds issued by Fannie Mae. While that's not technically a government agency, it has been effectively nationalized.


Option 2: If you're willing to venture further afield

Stir in some debt from Canberra, London, Ottawa ...

During the credit crisis, investors sought safety not only in U.S. Treasuries but also in government bonds issued by other nations. In 2008 the Barclays Capital Global Treasury bond index -- which tracks issues of investment-grade countries, including Australia, Britain, and Canada -- rose in lockstep with U.S. Treasuries.

Yet those bonds didn't fall when U.S. Treasuries did. From the start of 2009 through mid-November, they rose more than 10%. And they yield more than U.S. Treasuries -- nearly two percentage points more in the case of 10-year Australian bonds. Invest via a diversified fund such as SPDR Barclays Capital International Treasury (BWX).

Another reason to go abroad: exchange rates. The dollar has been losing value against other currencies in part because foreign appetite for U.S. assets is waning. As long as the trend continues -- which looks likely -- you'll make money on foreign bond funds even if the bonds themselves go nowhere.

In addition, put 10% of your bond portfolio in debt issued by countries with emerging economies, using a fund such as Fidelity New Markets Income (FNMIX). While those bonds expose you to more credit risk, they're a hedge against inflation. The fortunes of many governments in Latin America and Asia are dependent on raw materials and commodities, whose prices tend to climb when inflation does.


Option 3: if you're okay taking on a bit more credit risk

Add high-quality munis and corporates to the mix

Unlike the federal government, municipalities have been known to default. But fewer than 0.1% of those whose debt was rated investment grade defaulted in the past decade.

Even in the recession-racked early 1980s, the rate rose to only about 1.5%. So credit risk isn't huge -- especially if you stick with high-grade issues in a diversified fund such as Vanguard Intermediate-Term Tax Exempt (VWITX).

And when you factor in that munis are free from federal tax, high-quality munis offer a better yield than Treasuries today. Normally munis pay about 80% of what Treasuries do; now AAA-rated munis are yielding more than 90%, on average. "That's a bargain," says George Strickland, portfolio manager with Thornburg Investment Management.

As for corporate bonds, the average intermediate-term fund holding them lost around 5% of its value in 2008, then rose more than 14% to mid-November 2009. If you own corporates as part of a diversified bond portfolio, they can actually reduce your potential exposure to losses.

If your bond portfolio contains nothing but Treasury funds, redeploying your money according to these model portfolios is easy enough.

But what if most of your fixed-income money is in a blended fund such as the Vanguard Total Bond Market index (VBMFX)? Check what it invests in. The Vanguard fund is typical: More than a third is in Treasury and U.S. agency bonds; nearly a third is in corporates and foreign bonds; the remainder is mostly in mortgage-backed securities.

It's perfectly reasonable to keep a large stake in that or a similar fund, as long as you use the rest of your fixed-income money to add munis and foreign bonds.

Either way, what you end up with may not be as "safe" as an all T-bond portfolio. But it will certainly be less volatile and should throw off appreciably more income to boot. Sounds like a pretty good tradeoff.


From CNN Money published on Jan 19 2010

Types of Bonds

Most bonds you'll come across have been issued by one of three groups: the U.S. government, state and local governments or corporations. But to confuse things, these entities issue many different types of bonds that run the gamut in terms of risk and reward. Here's a quick introduction to the ones you'll encounter most often.




U.S. Government Bonds

The bonds issued by Uncle Sam are called Treasurys. They're grouped in three categories.


U.S. Treasury bills -- maturities from 90 days to one year

U.S. Treasury notes -- maturities from two to 10 years

U.S. Treasury bonds -- maturities from 10 to 30 years


Treasurys are widely regarded as the safest bond investments, because they are backed by "the full faith and credit" of the U.S. government. In other words, unless something apocalyptic occurs, you'll most certainly get paid back. Since bonds of longer maturity tend to have higher interest rates (coupons) because you're assuming more risk, a 30-year Treasury has more upside than a 90-day T-bill or a five-year note. But it also carries the potential for considerably more downside in terms of inflation and credit risk (see previous lecture).



Compared to other types of bonds, however, even that 30-year Treasury is considered safe. And there's another benefit to Treasurys: The income you earn is exempt from state and local taxes.



Municipal Bonds

Municipal bonds are a step up on the risk scale from Treasurys, but they make up for it in tax trickery. Thanks to the U.S. Constitution, the federal government can't tax interest on state or local bonds (and vice versa). Better yet, a local government will often exempt its own citizens from taxes on its bonds, so that many munis are safe from city, state and federal taxes. (This happy state of affairs is known as being triple tax-free.)



These breaks, of course, come at a cost: Because tax-free income is so enticing to high-income investors, triple tax-free munis generally offer a lower coupon rate than equivalent taxable bonds. But depending on your tax rate, your net return may be higher than it would be on a regular bond.



Corporate Bonds

Corporate bonds are generally the riskiest fixed-income securities of all because companies -- even large, stable ones -- are much more susceptible than governments to economic problems, mismanagement and competition. Cities do go bankrupt, but it's infrequent. Not so rare is the once-proud company brought low by foreign rivals or management missteps. Pan Am, LTV Steel and the Chrysler bankruptcies of 1979 come to mind.



That said, corporate bonds can also be the most lucrative fixed-income investment, since you are generally rewarded for the extra risk you're taking. The lower the company's credit quality, the higher the interest you're paid. Corporates come in several maturities:


Short term: one to five years

Intermediate term: five to 15 years

Long term: longer than 15 years


The credit quality of companies and governments is closely monitored by two major debt-rating agencies: Standard & Poor's and Moody's. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help determine the interest rate that company or government has to pay.



Corporations, of course, do everything they can to keep their credit ratings high -- the difference between an A rating and a Baa rating can mean millions of dollars in extra interest paid. But even companies with less-than-investment-grade (Ba and below) ratings issue bonds. These securities, known as high-yield, or "junk," bonds, are generally too speculative for the average investor, but they can provide spectacular returns.



Zero-Coupon Bonds

Zero-coupon bonds are fixed-income securities that don't make interest payments each year like regular bonds. Instead, the bond is sold at a deep discount to its face value and at maturity, the bondholder collects all of the compounded interest, plus the principal.



Why would you want to do that? Zeros are usually priced aggressively and are useful for investors who are looking for a set payout on a given date, instead of a stream of payments that they have to figure out where to invest elsewhere. People saving for college tuition and retirement are the prime targets. The SmartMoney college portfolios (see our College Investing section) make use of zero-coupon Treasurys -- known as Treasury strips -- for two reasons. First, you can buy them in a maturity that matches the date your child will enter college. And, they generally have a slightly higher yield than a regular bond.



Zeros do have a tax drawback, however, unless you hold them in a tax-deferred retirement account or an education IRA. Since interest is technically earned and compounded semiannually, holders of zeros are obliged to pay taxes each year on the interest as it accrues. That means you have to pay the tax before you get the money, which might be a struggle for some investors.




Published in http://www.finance.yahoo.com/