Ford, Fallen Angels, & Opportunities

Ford Motor was recently downgraded to Baa3 and placed on negative watch by Moody’s.  Why is this significant?  Well, at Ballast, we acquire assets in portfolios and believe we are capturing more return for the fundamental risk than we are taking.  Ford’s downgrade and this article address an area where we like to troll for opportunities – which are Fallen Angels.

Fallen Angels are companies whose credit rating has fallen from Investment Grade (IG) to High Yield (HY), and they are an area where market pricing sometimes reflects technical currents rather than economic fundamentals.  Even the Fed seems to agree – so let’s examine why.

The universe of IG is much larger then the universe of HY, both from a supply and a demand side.  On the supply side, the Bloomberg IG index is just over $5 trillion in size, while the Bloomberg HY index is $1.27 trillion.  On demand side, there are many more dollars allocated to IG than to HY. A quick example of this is an insurance company.  An average insurance company may have 50-55% of their total general account allocated to IG issuers, while their allocation to HY may be mid-single digits.  So, an insurance company (just like pensions, banks and other regulated institutions) has capital allocated to IG that is a multiple of what it allocates to HY.


Why does this matter?


Well, if a company is a large borrower – like in the case of Ford (which has about $35 billion in the IG index) – then it is heavily dependent on the debt markets for financing needs. Whether those needs be for operations, capex, or debt rollover, they are met by market participants (insurance, pensions, banks) that have lots of capital ready to be deployed. However, when a credit deteriorates and moves to HY from IG, then things get interesting.


Typically, large institutions (banks, insurance, pensions) have policies and/or risk-based capital charges that either restrict their ability OR make it very costly for them to invest in non-IG bonds.  Therefore, when an issuer no longer meets IG ratings, then that market participant no longer purchases that debt and, more likely, begins to sell the debt it already owns.  This selling pressure (from pure policy/regulated reasons) provides opportunities.


Simply put, when you have a lot of paper moving from a large pool into a small pool, it takes time and adjusted prices for you to reach equilibrium.  It is during this time that credit-minded investors can assess and source paper that provides attractive opportunities.


Note: Some fallen angels that we currently own are Diamond Offshore and TEVA Pharmaceuticals. 

It remains to be seen whether down the road Ford bonds will present an opportunity or not. However, rest assured we are following this – and other potential Fallen Angels – for opportunities to acquire assets at prices that don’t reflect their intrinsic value.

About Assets

Purchasing a good asset at a good price is an ideal investment proposition.

Purchasing a good asset at a bad price can be an investment that works out over time.

Purchasing a bad asset at any price tends to destroy one’s capital.


These three statements seem to be some simple rules to invest by – buy good assets, stay away from bad ones and get the best price possible.  How hard can this be? Every purchase decision requires the investment team to assess both the quality of the asset and the proper price to be paid for that asset.  Ballast spends time on this every day.


In today’s capital markets, it seems (actually it is more of a reality) that a lot of capital acquires assets without paying much attention to either the price being paid or the quality of asset being acquired.   Approximately 30% of money gets invested into the capital markets via a passive/allocation investment process.  Think of 401(k) contributions where RIAs method is to ‘asset allocate’ people into a model portfolio or some other passive investing strategy.  If you are in an ‘asset allocation’ you effectively are buying large swaths of assets regardless of the underlying value of those assets nor any assessment of the value of those assets. However, you are merely betting that (in aggregate) the group of underlying assets will achieve returns and perhaps (more accurately) the correlations of returns that repeat themselves.


An example of someone acquiring an asset whose underlying value has nothing to do with your personal investment objective is the Japanese 10 year bond.  This bond yields a negative 0.54%, which means you pay Japan 54 bps per year to hold your money for 10 years.  Ballast expects to be paid for others to use your money – not the other way around.  However, if your fixed income allocation is one of the Blackrock, PIMCO, Janus or American bond funds, you own something you wouldn’t likely own if you were more thoughtful.

These are the top holders of a Japanese bond that has a negative yield to it.  Some of the more widely known fund manager names are Blackrock #2, PIMCO #3, Janus #14, and American Funds #18.  Our point is when you own funds, you often own securities that you would never buy for yourself (since in this particular case we would not pay Japan 50 bps of yield per year to hold our money) and we don’t think you should either.


This leaves a lot of questions in our mind. What if history doesn’t repeat itself?  What if my starting point along that timeline is the wrong point in time? Is my investment objective then really just a function of broad asset classes?   In our humble but firm opinion, these questions are valid. Our answers to these questions suggest that acquiring an asset (security selection) and building a portfolio (institutional investing) is more intellectually thoughtful – and time intensive – than a simple mathematical model. 

At Ballast, we focus on not only acquiring assets, but also managing them. It means taking the time to analyze both the quality and the price of the asset itself. That is our method.

A Renter’s Market Mentality

I have a faint memory of sitting around the dinner table at maybe 13 or 14 years old.  There was a discussion going on – the topic of which eludes my memory. However, I vividly remember the lesson and illustration provided by my father.  He summed it up this way –

 A ship captain at sea when setting course doesn’t measure his progress relative to the lights of other ships out at sea, especially since doing so could take you in a direction you don’t want to go.  Rather, the ship captain sets his course using something more permanent – like the stars.  From these, he knows whether he is on course to reach his destination.

We use this same philosophy here are Ballast.  In our opinion, each clients’ progress toward an investment goal is not a function of the other ships out at sea (‘the market’).  The market’s return isn’t what we are after. We know our client’s current location, and we know their destination.  The path we set course on isn’t some random walk that may or may not end up in our port of call. Rather, we construct a portfolio with instruments that move each ship in the direction it needs to go – regardless of what direction other ships are sailing OR what direction the market may be moving.


Furthermore, those instruments are not funds. That is, when you look through to the underlying objective of a fund, it has no bearing on what one wants to accomplish.  Having experience managing funds earlier in my career, I can attest that my strategy as a fund manager was not to make sure you moved forward, but it was to beat my benchmark. Why? Beating my benchmark meant more money in my pocket at the end of the year.  Therefore, you will see funds with high turnover ratios – since to outperform a benchmark requires buying and selling securities to capture relative value.  Relative value – what does this mean?


If my neighbor today gets a raise, I should feel great for him.  However, does that mean I should feel like I am falling behind on my goals?  I would hope not because the same logic would mean I should feel great with a 50% pay cut if he or she were to lose their job.  My neighbor’s circumstance has nothing to do with me attaining my goals.  Each person’s goals are mutually exclusive of one another.  If the market goes down and your portfolio declines (but not as much as the market), should you feel closer to your destination?  We would hope not, but the capital market game of ‘relative value’ educates you to believe you should feel good with this outcome.


What does this mean?  It means that today’s market has become a renter’s market.

People seem to be renting  their investments as opposed to owning their investments.  When one rents an investment, one cares about its performance relative to something else (and not for the absolute intrinsic value or purpose that the security plays in a portfolio).  Examples of renters’ money in today’s capital markets are things such as

  • money deployed chasing last quarters’ return
  • capital passively allocated (we won’t say ‘invested’ but ‘unmanaged’) based on how one asset class will perform relative to another
  • renting a security for a period of time with the strategy of capturing some relative price performance – whether up or down. It just needs to be better than the price of the other security.

None of these have anything to do with intrinsic value – just relative value.  We completely understand why this is the case since the entire retail industry’s business model revolves around accumulating assets – but we do not really see this as investing.

So, at the end of the day, our investment philosophy, our daily market activity and our investment decisions are based on what best fits into a portfolio (ship).  These are a function of your end goal AND your starting point. Over the course of the journey, they have nothing to do with the relative value of what is going on with the other ships out at sea.  We like to captain ships where we understand everything that impacts the direction the ship travels.  To this end, our portfolios tend to look different than a traditional advisors’ allocation process. In fact, they tend to look similar to large institutions that have an investment department doing the same daily activity and process that we do here at Ballast.