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The Quest for Yield
(attendance by registration)
Friday, November 7, 2014
Lerner Hall, Columbia University, 2920 Broadway, New York, New York
The Program for Financial Studies would like to thank BNP Paribas for sponsorship of the Fourth Annual Program for Financial Studies Conference.
|7:30||Registration and Continental Breakfast|
Panel I: Asset Management
Tano Santos, David L. and Elsie M. Dodd Professor of Finance and Co-Director, Heilbrunn Center for Graham and Dodd Investing
Panel II: Corporate Finance
Patrick Bolton, Barbara and David Zalaznick Professor of Business
|10:45-11:45||Student Luncheon with Panelists (open to Columbia Business School student conference registrants, panelists, and Executive Advisory Board Members of the Program for Financial Studies only)|
We are pleased to provide the following photographs from the Fourth Annual Program for Financial Studies Conference.
If you do not see the media viewer above, you can go directly to the Flickr slideshow.
The Fourth Annual Program for Financial Studies Conference: "The Quest for Yield" was held on Friday, November 7, 2014. The panel was moderated by Suresh Sundaresan, Chase Manhattan Bank Foundation Professor of Financial Institutions, Faculty Director, India Business Initiative and Academic Advisory Board Member, Program for Financial Studies.
Panel speakers included Ayman Hindy, Partner, Capula Investment Management; Gur Huberman, Robert G. Kirby Professor of Behavioral Finance; Danilo Ruas Santiago ’01, Partner, Rational Asset Management; Tano Santos, David L. and Elsie M. Dodd Professor of Finance and Co-Director, Heilbrunn Center for Graham and Dodd Investing.
The Fourth Annual Program for Financial Studies Conference: "The Quest for Yield" was held on Friday, November 7, 2014. The panel was moderated by John Moon, Managing Director, Morgan Stanley Private Equity, Adjunct Professor of Finance, Columbia Business School, and Executive Advisory Board Member, Program for Financial Studies.
Panel speakers included Patrick Bolton, Barbara and David Zalaznick Professor of Business and Co-Director of the Center for Contracts and Economic Organization, Columbia Law School; Michael J. Boublik ’90, Chairman of M&A for the Americas, Morgan Stanley; Jennifer M. Hill ’94, Global Banking and Markets, Bank of America Merrill Lynch; Neng Wang, Chong Khoon Lin Professor of Real Estate.
The Fourth Annual Program for Financial Studies Conference: "The Quest for Yield" was held on Friday, November 7, 2014. Mark T. Gallogly ’86 served as the keynote speaker for the event.
We are pleased to provide a copy of the keynote address from the Fourth Annual Program for Financial Studies Conference.
Mark T. Gallogly '86
Cofounder and Managing Partner, Centerbridge Partners and Member, Columbia Business School's Board of Overseers
Good morning. Thank you, Dean Hubbard, for that gracious introduction, and thank you, Professor Hodrick, for the invitation to speak today. I also want to thank my partner Jon Lewinsohn and colleague Steve Dickerson for their input on this presentation.
I want to congratulate Dean Hubbard on the big electoral win on Tuesday. Glenn and I are friends. We are also on different sides of the aisle. We share, however, a desire to move America forward.
Never, in recent economic history—arguably never in history—have interest rates been so low, for so many, for so long. Not just in the United States, but in developed markets around the world. The GOP takeover of the Senate likely promises increased scrutiny and perhaps pressure on the Fed. Perhaps in the Q&A we can touch on that.
The market anticipates the rates will stay low. U.S. capital markets are ever-creative and have responded by inventing new ways to achieve yield. This search for yield (or maybe stretch for yield) can be an opportunity or a danger. The danger can come quickly. In the next 30 minutes, I would like to talk a little bit about where we are now, what the market’s reaction has been, and what the future might be.
Before getting into the substance of my talk, a personal perspective on me, our firm, and our investment philosophy:
I am not an economist; I am an investor. This talk about rates should be taken with a grain of salt. I was at Blackstone for 16 years and was Head of Private Equity there. I co-founded Centerbridge Partners in 2005 with my partner, Jeff Aronson, who had spent his career at a credit-oriented hedge fund. Nine years later, Centerbridge now has $25 billion of assets under management and 200 people based in New York and London.
Centerbridge bridges two strategies to the center: Control-oriented private equity and non-control-oriented credit and liquid securities hedge fund.
I love CBS – I met my wife here. I was also taught to ask what is the competitive advantage of an organization. Our competitive advantage, I think, is that we are nimble. We invest highly complementary strategies which are generally countercyclical: one with a solid understanding of the asset side of the balance sheet—how businesses grow, performance strategy, operational improvement, profit growth, and employment growth. The other, the liability side of a balance sheet, markets, credit. Both with a focus on risk.
We manage the business with a single team of 65 investors working across nearly all industries buying up and down the capital structure from bank debt to common equity and hard assets (planes, trains, real estate).
As investors we are value-focused. Sometimes contrarian. Very much in the Ben Graham Intelligent Investor discipline. I was a student of Jim Rogers. Our first rule of investing: don’t lose money. Look for a margin of safety and focus on absolute returns.
So where are we today? Well, as Glenn could tell you, I am for many reasons bullish on the U.S. economy and our competitive positions. Perhaps that could be a discussion for another day. As it relates to interest rates in the search for yield, today’s market has virtually no historical antecedent.
Yields are famously low, but how low? In nominal terms, sovereign yields have only approached current levels in the aftermath of World War II, and what’s remarkable is that this is true across all major developed economies.
We can go back to the mid-1800s in the case of most developed nations (and even to the 16th century, in the case of the Netherlands) and observe yields that have rarely (if ever) been as low as they are today.
U.S long-bond yields (30yr) demonstrate this same trend—which is more remarkable when you consider that prior to the Great Depression, the U.S. experienced repeated (and sharp) periods of deflation, increasing the real value of low nominal yields.
As students of markets, we have seen rates follow long, secular periods of rise and fall; and if you consider the period in which modern private equity has existed, that form of investing has no doubt benefitted from a nearly relentless fall in the level of rates over a 35-year period. So we ask ourselves, what happens to our business when this trend reverses?
As an aside, private equity promises its investors a minimum return of around 10%. In other words, before the general partner shares in any profits, the limited partner receives 10%. If the market is right, the rates stay low, this strikes me as an excellent arrangement for the LP. Alternatively, if GPs reach to obtain traditional levels of return, the value proposition of the industry may be markedly different than it has been in the past.
The current trajectory of rates is remarkable not only in a nominal/absolute sense, but in a relative sense as well—owning long-duration debt has provided comparable total returns to equities over the past 15 years.
So—rates are historically low—but how did we get here? I am not going to get to the cause of the current environment. Recent speakers like James Gorman have looked at that. As slide 4 shows…
…many economists have been forecasting robust growth each year for the past several years, but only now is it materializing.
The chart on the left shows the so-called “output gap,” or the distance the current economy is from its potential. Not only do we remain far below our current potential, but that potential has also been revised downward from its pre-crisis trend—if you consider where GDP is relative to where we thought we’d be in 2007, we are nearly $3tn below and have determined that our basic assumptions to get there are no longer true.
This has dramatic implications for the labor market in the U.S.; the chart on the right is familiar and tells the story that this recovery has been slower than any other post-war recession in the United States.
To bring this back to markets, in a “normal” recovery (pre-crisis), bond yields rise, yield curves steepen, and equity prices rise. Let’s look at the 2000s. Rates and equities moved in tandem as an improving economic outlook supported earnings growth and led to a hawkish Fed.
Even in 2009, as the economy recovered from the worst of the recession, markets expected long-term rates to rise in line with a more traditional recovery.
This relationship broke down in 2010 as growth disappointed and markets reassessed the likely trajectory of future rates and the value of risk assets. The market went up while rates continued to decline.
The policy response from the Federal Reserve to the crisis (and to a limited fiscal response) was a dramatic repression of interest rates. And it worked, at least from a market perspective.
Equity markets appreciated sharply and unemployment began a gradual decline, though growth has remained uneven.
At this point, it’s reasonable to ask—how much of the market recovery was supported by fundamentals and how much was driven by Fed policy?
A hint lies in the fact that rates decoupled from equity markets as rates markets began to price in “low rates for longer.”
This decoupling became marked at the beginning of 2014, when the 5 year rate 5 years forward collapsed from 4.6% to 3.2% today. This was approximately the same level it was before Chairman Bernanke announced the taper in May 2013. This move is striking. It implies the market deeply questions long-term U.S. growth, the 5.9% headline employment number, and the stated Fed policy of modestly increasing rates beginning next year.
So to reiterate—rates are very low, growth has been elusive, and the Fed’s reaction is playing a role in the pricing of risk assets and the market’s behavior.
Seven years after the start of the financial crisis, economic and financial conditions remain far from normal. In “low rates for longer,” some of the traditional relationships that have governed the way in which markets and cycles evolve have broken down and the value of historical analysis may have weakened.
The vibrancy and creativity of U.S. capital markets has, over time, reacted to this low rate environment: for example, in the growth of Master Limited Partnerships. MLPs are tax-advantaged publicly traded partnerships that must derive 90% of their income from real estate, natural resources, or commodities. MLPs distribute nearly all their income and are typically valued on yield rather than earnings. These products, not surprisingly, are primarily owned by retail investors—a recent Morgan Stanley report descripted MLPs as “one of the best places to get current income.”
Historically MLPs have been concentrated among infrastructure E&P assets (e.g. pipelines) that have “bond-like” cash flows and for which a yield-based valuation is perhaps appropriate. Distribution coverages are typically low (1.05-1.1x) and the structures are leveraged—any shortfall in earnings can lead to reduced or no distributions, so stability is key.
Post-crisis, there has been dramatic growth in MLP formation, including the creation of non-traditional MLPs, where underlying earnings volatility should give investors pause about whether their long-term distributions are truly “bond-like.”
At Centerbridge, we call these “equities masquerading as bonds” —products designed in a low-rate environment, and that can only work as long as rates stay low.
Here’s a specific MLP example. HiCrush sells sand used in frac operations—it’s a commodity product which is subject to large price fluctuations based on end-market demand, and ultimately, the price of oil.
If you purchased HiCrush equity in early August, you were setting up a dividend yield of all of 3% (nearly 18x EBITDA) for a commodity-like underlying cash-flow stream; plenty of equities and credits have suffered based on the recent move in energy prices, but this is an example where not only were investors’ assumptions incorrect about energy and price; they were structurally incorrect.
MLPs are far from the only so-called “yieldcos” the market has embraced—utilities, REITs, and BDCs all deliver mid-to-high single digit yields to investors with varying degrees of leverage and distribution risk. The key is that differences in quality do exist, and in a higher rate environment, selectivity will become important—even if it isn’t apparent today.
Here is another product that promises high current yield.
This is an overview of the trading history of the PIMCO Global StocksPLUS & Income ETF; it invests in equity and credit securities which it then transforms into a high current income through use of leverage and derivatives. Pre-crisis, the trading price closely reflected the Net Asset Value of the fund.
Post-crisis, this relationship has broken down—on the chart, you’ll see investors are willing to pay a 67% premium to the underlying assets to receive a 10% dividend yield. This same yield implies a 15% cash return on assets—looking at how little yield exists today in risk products, we should be skeptical of this on its face.
And indeed, in this case, we have good reason to be—30% of distributions are actually returns of capital, not returns on capital.
Lastly, we’ll look at a striking example of how important central banks have become to market valuations:
A counterintuitive result (at least to me): European HY spreads are tighter than US spreads today (notwithstanding very different fundamental outlooks).
If U.S. Treasury securities offered 4% yields (closer to historical norms), how would capital look at yield in securities of structurally-challenged European markets? If capital left these markets in size, what would the implications be for those economies?
Though this chart shows spreads, we can ask similar questions about European sovereigns—in June, Bulgaria, the poorest country in the EU, issued its largest bond ever at a yield of 3.05%—if a 10yr Treasury offered substantially more than 2.3%, where would this opportunity have priced? The global availability of capital is premised on a certain rate environment—what might happen if this environment changes?
So, rates are very low and the market has reacted in very natural ways. Capital has flowed into risk asset classes as investors look to increase current yield (in some instances, with disregard for incremental risk associated with achieving that yield).
Where do we go from here? Let’s look at the potentially bookend outcomes; we can also examine how the world might change if the risk pendulum swings back and how those types of changes have impacted markets in the past.
One end of the bookend could be that markets are largely “right”; although nominal growth has been modest, the U.S. is accelerating and inflation remains low.
A prolonged period of “deflationary growth” would be excellent for credit (rates actually do stay low) and would be supportive of current equity valuations. Depending on growth, perhaps even higher valuation.
As long as rate volatility remains contained, the market should absorb minor shocks and most assets should perform well.
We should note that markets have often been wrong about future interest rates. Let’s examine some history.
We’re looking at the 5 year expectation of 5 year rates, on a 5 year lag. In other words, comparing what the market expected for the 5 year vs. what it actually was.
The market typically expects an upward sloping yield curve, so it’s not surprising actual rates have been lower than market-implied projections. However, if we look at the market expectation today (that the 5 year will be at 3.2% 5 years from now), we see it’s at the same level it was before Chairman Bernanke announced the taper—that’s pretty low considering QE just ended.
So what is the other side of the bookend? A rate hike could catch the market off guard. This isn’t so farfetched—the U.S. may be poised for modest growth, headline unemployment is below 6%, and there are budding signs of wage inflation.
What might a hike look like in the markets?
The last time the market was truly caught off guard by a tightening was 1994:
In ’94 Chairman Greenspan surprised markets by raising rates after years without a move; over the course of 5 months, rates jumped 200bps and equity markets reset. A key feature of this rate move was that it was in response to strong growth; a reasonable conclusion is that growth may not be enough if valuations are too dependent on rates.
We can get hints of how an unwind might look during two recent episodes of rate volatility.
In mid-2013, you saw people sprint for the exits when the mere suggestion of rate increases reminded people of the mid-’90s; taper talk and fear the Fed would finally raise rates caught the market a bit off guard—rates sold off and volatility increased.
In the second instance (Aug/Sep ’14), concerns about global growth pushed the market toward a view of QE lasting longer and the Fed reversing the taper—rates rallied and volatility also leaped.
In both cases, HY underperformed—when the market is this tight, investors can’t stomach volatility.
So if the rate picture changes, how will the unwind compare with past experience? One thing to consider is how the bond market—the context—has changed since the crisis. The rise of ETFs and mutual funds as an asset class has dramatically shifted how bonds and credit are owned today.
ETFs/mutual funds allow daily redemptions, but the underlying instruments might trade in only a small amount each day; traditionally, dealers bridged the gap by holding inventory and stepping in when liquidity was short. The post-crisis regulatory regime has changed this and now dealers hold a fraction of what they used to, even as the total credit market has grown.
If investors demand liquidity at once, the market may be full of sellers and without buyers, exacerbating jumps in price volatility.
The muni market has always had many of these same characteristics (funds offer daily liquidity to retail, dealer inventories are low, and bonds trade infrequently).
In the summer of ‘13, a series of negative headlines sparked a sell off in Puerto Rican credit and prices gapped downward. Ultimately a non-traditional buyer base emerged, but not before a broad reset across Puerto Rican muni credit had occurred that left par-holders with substantial losses.
This may be a good example of how limited liquidity can lead to volatility and create opportunity for those with capital and patience.
In addition to supporting low yields on security prices, the rate environment also has second order effect on credit fundamentals:
With inexpensive leverage available to almost all high-yield issuers, interest coverage has rebounded quickly post-crisis as borrowers lock in low rates and push out maturities.
The increased duration is cause for concern itself from an investor’s perspective, but if borrowers are required to refinance in a higher-rate environment, their credit will be fundamentally less attractive—these companies seem less levered than they actually are.
A high-yield issuer who funds at 5.5% today would see their coverage ratio drop by 30% if they were forced to refinance at 2007 HY rates (8.1%); this implies a coverage drop from 4.0x to 2.7x, a low for the past 10 years.
A lot of this should give us reasonable pause: rates are very low, there’s reason to think markets have reoriented to a long-term presumption of low rates, and the unwind may be faster and therefore more dangerous than expected.
How do we think about investing in an environment like this?
In our control business, selection is key—we can buy businesses that don’t require low rates to work and are able to increase share in low or no-growth environments. We can structure as scenarios. Also, when we buy businesses with leverage we are sellers of credit—and the environment is very attractive to be an issuer.
In our non-control business we remain more wary—we focus on absolute return, not yield, and select securities which have idiosyncratic return potential and a margin of safety. We don’t use leverage and we maintain capital flexibility—for us, this makes dislocations opportunities.
We are in an unprecedented environment today. Rates are very low, both on an absolute and relative basis. The danger is markets are highly accommodative of this environment, both in how risk is priced and how financial products are designed. Markets can react sharply to surprises and changing circumstances. This should create opportunities for patient, careful investors.