07/2018 Market Commentary

Triple C Priced to Perfection

We opened a market brief on Bloomberg (no public link available; for anyone with a terminal: {NSN PCQ8R66K50Y0 <GO>}) by accident to close out the month on July 31, but it made us pause. Key lines of the brief are as follows:

  • CCC yield fell to 7.89% (lower since Sept. 22, 2014) after the steepest drop since Dec. 30, 2008.
  • CCC spreads are closed at a 4Y low of +512, the biggest decline in 10 years.
  • Morgan Stanley warned investors about ‘significant potential downside’ in CCC credits.

For starters, we don’t often find ourselves in the camp on Morgan Stanley, and yet here we are. Investors are still evidently zealous for yield. This surprises us with all the talk of bond bubble, record weakness in covenants, and zombie companies. We think there are a lot of places to not be invested at this point in the cycle and this part of the credit curve is (generally) one of them.

We think yield-starved investors continue to push capital wherever yields surface. We suspect the biggest conduits and investors to be Business Development Corporations (publicly traded small and medium enterprise lenders) and Collateralized Loan Obligations (CLO), and they are the primary enablers for this market. The former is available to and popular with retail investors, while the latter has been hot with institutional investors.

CLO's are Forever

Until they are not. Quantitative minded investors have been effective at observing historical losses of the asset class and calculating excess returns. If you are an institution looking for good relative value, this has been the place to be. With the recent resurgence in CLO interest (since the last cycle end – Great Financial Crisis), many new CLO managers have surfaced and met rising demand for their product. The problem is the CLO owner is beholden to many things out of their control, and when the market turns, liquidity goes away. It is not until then that investors will find out how good their CLO manager is – only with hindsight. And those historical losses – we’ll see if the next is the same as the last. In the meantime, sounds like the CLO market started to flash warning signs.

Tesla Tesla Tesla

A reference to the Brady Bunch or summoning Candyman? Elon Musk was summoned by a critic of Tesla, writing under the pseudonym Montana Skeptic on Seeking Alpha, and Musk silenced the critic. The analyst and an editor of Seeking Alpha both commented on the event and confirmed. Montana Skeptic, to keep his employer from public scrutiny, as well out of legal wrangling, agreed to cease writing about Tesla.

That was not it though, as a lot happened during July for Tesla. Remember, Tesla’s cash flow has been of critical focus, and many suspect the company will need to do raise capital – which Musk has strongly denied. In addition to the silencing mentioned above, we summarize the month here:

  • Tesla is thinking about building a Tesla Gigafactory in Europe. This could provide cover for capital raise…even though it is not needed…
  • Tesla is thinking about building a Tesla Gigafactory in China. This could provide cover for a capital raise…even though it is not needed…
  • There were more high profile executive departures.
  • There was distraction with sending help (ultimately determined unneeded) and equipment to the Thai cave rescue.
    • Elon Musk then, very publicly, skirmished with the rescue lead and certain divers about ego things.
    • Elon Musk disparaged at least one diver in an unacceptable way, deleted the Tweet, and publicly apologized.
  • Car sale prices increased in China.

The FANG index, comprised of the crème de la crème of tech high fliers (Facebook, Apple, Netflix, Google, Amazon, Twitter, Tesla, et al), was soaring, but it hit turbulence in late July and has plummeted to correction territory. Leading the charge lower was Netflix, Facebook, and Twitter with poorly received quarterly financial results. While the index may not be Icarus, some of the constituents may be. The result is something we recommend staying away from. We continue to strategize ways of expressing our views around these select names in ways that are productive to accounts, but these are expensive times in the tech investment world.

GDP Hits 4.1%

Where is the beef? It is one quarter, and the reading spikes on occasion. Not to mention, it is often later revised as lower. The annual reading is likely to be no different than the previous few years. While headline unemployment is giving people something to cheer about, employment slack is a huge overhang for the next few years. Wages, in real terms, have treaded water (at best) for the last decade. Inflation is not budging. Celebrate not. We are not out of this yet.

Marginal Buyer. Minsky Moment?

For several years, China-based investors were the marginal buyer in capital markets. In real estate, market valuations are viewed in terms of cap rates (or the discount rate with which to value a property given its net operating income). A lower cap rate translates to a higher value and vice versa. Rewind a few years and US investors were already taking pause at the historically low cap rates. Then, China-based investors entered, and they drove cap rates even lower. Risks were mounting at home in China, and investors were prepared to take big risks overseas. In an already highly valued (real estate) market, they became the marginal buyer and were seemingly prepared to pay anything. Fast forward to today and these China-based investors are now sellers. But who is the marginal buyer today? Will they pay even lower cap rates?

Liar’s Poker – A Book Review

As some of you may already know, Liar’s Poker is the first book published by Michael Lewis in 1989. It is basically a synopsis of his career at Salomon Brothers in the 1980’s. If you are not familiar with Michael Lewis, he is also the author of Moneyball, The Blind Side, and The Big Short.

Lewis – through acquaintances and the fortune of being seated next to the wife of the managing director of the London office of Salomon Brothers – received an invitation to the highly coveted Salomon Brothers training program.  At that time, it was considered by many to be THE Wall Street bond trader training program.

Salomon Brothers was thriving in the 1980’s as they basically invented the mortgage backed security, and they had a monopoly on the packaging and selling of these securities to banks, insurance companies, pensions funds, etc.  Prior to this, institutional investors shied away from investing their funds in residential mortgage loans, as the homeowner could always prepay if interest rates were going down (and the homeowner could refinance at a lower rate).  Institutions like to know the duration of what they own.

Even though this is a story of happenings 30 or more years ago, there are lessons in this book that apply both to today and to the future.  First, Salomon Brothers was thriving with their newly invented mortgage backed securities that gave investors some comfort in the duration of what they were buying.  They had all of the intellectual capital and the relationships in this space.  A couple of the reasons they didn’t maintain the good thing they had going was greed of upper management and jealousy of people in the organization that weren’t in the mortgage trading department.  Individuals who were integral in the buying of loans from thrifts throughout the U.S.(packaging them into mortgage backed securities and selling these packaged instruments to investors throughout the world) were aware that what they were doing was highly profitable.  Other Wall Street firms also became aware that it was highly profitable.  Competing firms (Goldman Sachs, JP Morgan, etc.) came with 7-digit salary offers to key personnel, and within a short time, many of the key people were successfully doing the work they had done (at Solomon Brothers) at other Wall Street firms.

So, Lesson #1…reward your good people.  Stay in tune to what is going on in your organization culturally, and do whatever you need to do to keep your key people engaged and excited about the growth of the organization as a whole.  In addition, ensure that their production will be rewarded fairly.


Lesson #2… Make sure your investment professional is on the buy side. This lesson is highlighted when Michael Lewis is assigned to the bond trading desk in the London office of Salomon Brothers.  This lesson is one that we (here at Ballast) talk about frequently.  Upon assignment to the London office, Lewis was told to call on investors and get them to entrust their funds to the firm.  He wasn’t great at this, but he did get a good lead one day and called on a local bank that wanted to invest $20 million with Salomon Brothers.  A bond trader within Salomon Brothers told Lewis that he should sell the bank some AT&T bonds.  Lewis went with the trader’s advice and suggested to the bank representative that they invest in some AT&T bonds.  Little did Lewis know that these bonds were in a loss position, and the trader had been trying to get them out of the Salomon Brothers’ portfolio.  The local bank’s first position (the AT&T bonds) with Salomon Brothers was down in price the very first week they owned it.  Lewis felt terrible about putting the bank in a bad investment from the get go and asked the bond trader who suggested it if Salomon Brothers could buy them back from the investor at cost as a goodwill gesture.  The trader responded, “Who do you think you work for, Michael?”


Even though it appears that Lewis was on the buy side for an investor who was definitely on the buy side of the AT&T bond trade, Lewis was with Salomon Brothers who was on the sell side of the trade (therefore Lewis was on the sell side as well). And so the lesson is…if you are working with an investment professional to put your savings to work, make sure they are on the “buy-side.”  I want to reiterate this point, because it’s important: In the example above, Salomon Brothers had the appearance of being on both the sell side (the bond trader telling Lewis to push the AT&T bonds) and the buy side (Michael Lewis trying to do a good job for an investor).  But their strategic interests were purely sell side.

This structure still exists today.  Wall Street investment banks have their own portfolios and are underwriting securities that they are selling to investors.  These same banks (sell side) have thousands of investment advisors in the retail arena advising individual investors (buy side).  The charge of the Wall Street banks is to collect capital via selling debt or equity securities to investors.  The charge of the investment advisor is to act in a fiduciarily responsible manner, investing clients’ funds in positions that are strategically aligned with their clients’ financial goals.  It seems that there is a conflicting set of goals when firms are acting on both the sell side and the buy side, and this is how many Wall Street firms grow their business (Morgan Stanley, J.P. Morgan, Wells Fargo, etc.).  Yet, many individual investors feel comfort and safety when investing with a large, “reputable” Wall Street name.

You, as an investor, are always on the buy side.  Make certain the investment professional you are paying and trusting to put you in good, productive investments that are accomplishing your financial goals is also only on the buy side!!  You want your interests aligned…always!