Is the Worst of It Behind Us?

The past quarter consisted of two very distinct halves, with the latter being much more prosperous for Income Opportunity Strategy. Between the start of the quarter and the Strategy’s performance trough on February 11th (also the day the market bottomed), Income Opportunity lost -17.62% (net of fees),¹ underperforming both the BofA ML High-Yield Master II Index as well as the S&P 500. Between February 11th and the end of the quarter, Income Opportunity Strategy returned 19.63% (net of fees),¹ outpacing both the aforementioned indices, though the Strategy remained slightly behind both unmanaged indices year-to-date through quarter-end. In our last investor letter, we discussed why we thought performance had declined despite our holdings’ cash flows and dividends remaining relatively steady. We cited a possible Minsky moment in income-generating securities, as well as extremely high risk aversion, which is evident in widening credit spreads. It is the credit spread topic we’d like to explore a bit more fully below.

A corporate “credit spread” is the marginal return investors require above a government bond with a similar maturity date, because there is almost no risk that today’s US government will not repay its debts. At the end of February 2014, the ten-year US government bond yielded 2.65%, and the yield-to-worst on the high-yield index was 5.21%. The difference between the two numbers, or the “credit spread,” was 2.56%. On the Strategy’s February 11th performance low, the ten-year bond yield also hit its intra-quarter low of 1.66%, while the high-yield index’s yield-to-worst hit its intra-quarter peak of 10.10%, implying a credit spread of 8.44%.

In other words, Income Opportunity had 588 basis points of spread widening to contend with over 2 years ending in Q1 ‘16. Credit spreads widen when investors believe economic challenges may reduce the probability of future cash flows, which puts downward pressure on current prices. While we do not necessarily view the credit spread widening as warranted, it is the mechanics of today’s spread widening that have been especially difficult, as not all credit spreads are created equal. Since the creation of high-yield bonds in the 1980s, this is the second-worst case of “relative spread widening” we have ever seen. At the February 11th market lows, the high-yield index yielded 6.1x what the US government bond did. Since the invention of junk bonds in the 1980s, there has only been one period when junk bonds yielded a higher multiple of the ten-year, and that was during the depths of the financial crisis, when junk bonds yielded just over 10x what the ten-year did in December of 2008. The compounding nature of bond math means that it is not just the absolute extent of spread widening that matters, but the level of rates as well. The difference in present value owing to spread widening is especially pronounced for longer-duration assets like credit-sensitive equities, which is where a substantial portion of the Strategy is allocated.

Clearly, the spread widening and growing risk aversion have been head winds to performance. The good news is that today’s environment is not dissimilar to the one in which we launched the Strategy in 2009, which proved to be a good entry point. Both on a stand-alone basis and relative to the 10-year yield, today’s credit spreads are attractive when compared to history. Since October of 1994 through the end of Q1 ’16, the absolute level of credit spreads has been narrower 80% of the time, while junk yields as a multiple of the ten-year bond have been lower 97% of the time. We think this bodes well for the Strategy, though we cannot promise that spreads will narrow. We remain the largest investors in Income Opportunity Strategy and welcome any comments or questions.

Strategy Highlights

During the first quarter of 2016, the Income Opportunity Strategy returned -1.30% (net of fees).¹ In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned 3.25% and 1.35%, respectively.

The Strategy initiated ten positions and eliminated 13 during the quarter, ending the quarter with 45 holdings.

Top Contributors

VEREIT, Inc. (VER) rebounded in the first quarter, rising 13.77%. Fourth quarter results were in-line with Street expectations, and the company continued to execute on its turnaround plan by selling properties and reducing debt.
Frontier Communications Pfd 11.125% 06/29/18 was up 17.09% during the quarter supported by solid fourth quarter results. Revenues and adj. EBITDA were roughly in-line with consensus while FCF numbers beat the guidance for the year. On April 1st, Frontier announced the close of its $10.45B acquisition of VZ assets in California, Texas and Florida. Management increased its estimates for day-one synergies to $600M from $525M.
While the Genworth Holdings Inc. 6.515% 5/22/18 was up only 1.14% during the quarter, the Income Opportunity Strategy’s timely purchase of the issue resulted in the security increasing 19.37% over the period that the strategy held it. During the period, Genworth announced the plan to separate the long-term care business from the other life businesses.

Top Detractors

SUNEDISON Inc. pfd 6.75% 12/31/49 ended the first quarter down -70.31% as the market became increasingly concerned with the company’s ability to fund its commitments. Over the period, SUNEDISON announced a restructuring of its solar materials plants, including the sale of one facility and the shutting of others that are not cost-competitive. The fund sold the preferred issue shortly before the announcement that the dividends would be suspended to preserve liquidity.
Calumet Specialty Product Partners L.P. (CLMT) continued its decline over the quarter, ending the period down 34.30%. Calumet reported weak results in the fourth quarter sparking questions on the sustainability of the distribution. Management maintains that they are prioritizing liquidity and continuation of distributions.
Altisource Residential Corp. (RESI) ended the first quarter down -26.32%, impacted by a fourth quarter EPS loss but showing progress in winding down its NPL strategy. Altisource resolved the uncertainty around the dividend by reducing it, and we no longer own this security.

¹Income Opportunity Strategy performance reflects the deduction of an annual model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this commentary reflect those of LMM LLC (LMM) portfolio manager(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading on behalf of any portfolio. Any data cited is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.