March 18, 2020
Strategic Income Investing in a Volatile Market
A Q&A with Bill Miller IV, co-portfolio manager of the Income Strategy
Q: What is the bond market telling us today?
Bill Miller IV: I think it’s important to look across capital markets broadly for signals, especially in this kind of environment. The market is telling me number one, people are absolutely terrified. And number two, there’s just not enough liquidity in the system until now.
People’s fear is pretty clear given the 24/7 news cycle around the coronavirus, which predominantly affects the elderly. [Thursday] was the worst day in the stock market in over 30 years. Why is that? First and foremost, you have institutional closures of schools, basketball leagues and all kinds of stuff globally weighing heavily on economic demand, as well as the velocity of money or people essentially – the rate at which people transact or buy goods and services. We need an offset to that now.
Liquidity had completely dried up [Thursday] in even the most liquid markets in the world. We were hearing point-and-a-half spreads on treasuries. People were selling everything, including treasuries, perceived safety, utilities, investment-grade bonds. If you compare LQD, the investment-grade bond ETF, performance over the past week to its underlying index, there’s some interesting discrepancies there.
The underlying index, which is based on bonds that may or may not trade, was down 8% in the past week. But the actual traded liquid ETF wrapper, LQD, is off 12%, a meaningful gap between the ETF wrapper and its underlying index. Why is that? Mainly because there are mismatches of liquidity out there due to there being none.
Prior to Thursday, no one had stepped up to fill that void until historic action from the Federal Reserve in the form of $1.5 trillion in new funding, $500 billion of which hit [Thursday], and a trillion is hitting today. It’s also important to note that this latest historic liquidity injection is split between a one-month term and a three-month term. Why is that important to note? Mainly because prior funding offerings only had a two-week term. That was part of this package. They’ve also said they’re going to offer even another trillion with a weekly term, so a ton – just an absolute ton of new liquidity to offset those gaps we saw yesterday.
That’s important because fiscal policymakers may be slow to respond, especially those who might want to see some changes in the upcoming election in November. I think it’s important to note that monetary policy has consistently been too tight, consistently failing to achieve its own stated objective of a “2 percent symmetric return goal.” They’ve had what I would refer to as an obsession over “normalizing rates,” meaning making them way higher than they are today, as well as “normalizing the balance sheet” and letting all of these assets run off.
Now the market is forcing them to loosen up again. We did an analysis of the Federal Reserve’s balance sheet going back 100 years. It showed that the Federal Reserve’s balance sheet over the past 100 years grows, that’s what it does. And so, you had a unique situation where they were shrinking the balance sheet, in addition to raising the rates. That was just not okay. Now we have a much better situation.
In our Q3 shareholder letter from 2015 called “The Fed: Data-Dependent or Date-Dependent?”, I flagged that after the Great Depression short-term rates didn’t get to 1% for 20 years. There we were, six years from the bottom, with The Fed starting to hike rates pretty much monotonically. So every couple of months, 25 basis points (bps) higher, 25 bps higher, 25 bps higher, all the way to a target federal funds rate of 2.375%.
Now, this rate was just 10 years after the financial crisis, and the value destruction of which was on par with the Great Depression. And again, it took 20 years after the Great Depression for the short-term rate to get back to 1%.
So what’s the bond market saying this morning? They’re saying the Fed is going back to zero by next week despite last week’s historic mid-meeting cut of 50 basis points and today’s massive liquidity injection. If you look at the term structure of VIX Futures – I think that’s really interesting to look at because it shows what the market’s expectation is for volatility in a month or two – it’s telling us that the current bout of market volatility is likely going to be at much more normal levels by the end of May, if not before, so that’s a very positive sign.
Q: Income Strategy has been positioned pro-cyclically. Given recent events, have you changed your thinking about how the Strategy is positioned?
Miller IV: My thinking has changed in that I wish two weeks ago we put the entire strategy in cash, but we didn’t. But as widespread panic and liquidity collapses are not high-probability events, and cash is not a high-yielding asset or pro-cyclical asset, we didn’t do that.
After this sort of size of pullback in the market, and what’s going on in the liquidity front, I think it’s a time to play offense. In general, the economy grows, people solve problems and asset values go up. We really can’t have a big deflationary environment in this country – that’s what the financial crisis showed us.
The entire capital structure of consumers and businesses just can’t take that when we have huge, fixed-rate costs in them. For consumers, that’s their mortgage, and for businesses, a lot of times that’s debt and other costs. The economy is predicated on the dollar’s value eroding slowly over time. So, to answer the question, no, it hasn’t changed my thinking all that much. We’re going to continue to be a pro-cyclical income strategy to try to play offense because we think that’s where you’re likely to see the best returns over the long term, especially from this starting point.
Q: There are probably many people who also wish they moved entirely to cash before the market volatility. But of course, you can’t predict that and it’s important to have a long-term perspective. The Income Strategy is flexible – it can invest across the capital structure and across asset classes. Generally speaking, where are you seeing the opportunities? Equities? Bonds?
Miller IV: Well, if you’d asked me [Thursday], I would have said it depends on the bond and the price where we can actually transact, but today I feel much better about that. There are opportunities I think in both at this point, but the marginal return profile, if you want to make a lot of money at this point, I think is in equities and in a lot of the stuff that’s been hard hit.
One of the areas that’s been completely smashed that we absolutely love are theme parks. Obviously, coronavirus is going to weigh heavily on attendance and potentially spending at some of them. But we think the valuations and the changes in price we’ve seen more than reflect all of those facts.
Cedar Fair, which we’ve owned on and off for years, own 13 parks across the country – two waterparks in Texas and 11 parks in various spots scattered about. The company, which has been around for 30 years, lost 65% of its equity value in three weeks. Today, you can buy Cedar Fair at about 6x EV to “normalized” EBITDA. That’s below its valuation in the financial crisis when there were real existential threats to the business.
All you have to do to think about this one is ask yourself has the coronavirus fundamentally impaired the value of rollercoasters by two-thirds in the past three weeks. We don’t think so. Their parks are pretty unique. Their rollercoasters are something you can’t replace at home. Unlike other high-yield names that face secular threats, these are real assets. They’re unique.
In the past 30 years, Cedar Fair has had three down years of EBITDA. This could be number four, but that’s already baked in given the stock is down 65%. Their debt has actually been trading and transacted in the past couple of days. And what is that market telling us about Cedar Fair’s prospect? Namely, they’re totally fine. The debt trade yields between 3.9% and 6.9 %, depending on maturity and seniority, which tells you there’s no existential risk for Cedar Fair. Yet a downdraft of two-thirds over two weeks on the equity tells us the opposite. We think these equities are very attractively priced. There’s a lot of stuff out there I’m buying in this environment where the prices are unique. We’re trying to be opportunistic and take advantage of that.
Q: You can certainly see the benefits of having an active approach in this kind of market environment. Looking at the high yield market, there’s been some concerns obviously with some companies that have a high degree of leverage on the books. Do you expect default rates to materially pick up given what we’ve seen with the slowdown and the concerns in the market?
Miller IV: I think they’re absolutely going to pick up, mainly in industries that have high fixed costs affected most by the slowdown in activity. Energy would be a big likely source of upcoming defaults, potentially some cruise lines and travel things. We haven’t seen that pickup yet, but certainly the market’s telling you that we’re likely to see that in pockets.
Q: Is there anything you’re avoiding? That you can’t wrap your head around, or you can’t really assess fundamentally?
Miller IV: I mentioned investment-grade bonds earlier and utilities – neither of which looks to offer great value for the long-term holder. They may offer some stability, interestingly enough. They both sold off [Thursday] in the panic, so we don’t think those are great things to own. We’re looking for things with some displaced valuations and trying to buy those.
Q: Is this a good time to invest in the Strategy?
Miller IV: Lower prices are always better buying opportunities for long-term investors, and this is among the lowest pricing that we’ve seen in a while. If you’re an investor who wants a little extra yield and are overweight really high-quality stuff, I think you have a pretty high probability of looking good at the end of this year if you shift some of that ultra-high-grade stuff today into the Income Strategy.
When we look around, there’s a lot of reasons for optimism, as we’ve discussed. We’re seeing a lot of high insider buying at the companies in the portfolios. The reality, as I mentioned earlier, is that the world tends to grow. People want to solve problems and make things better. Over time, asset values tend to rise. I think there’s a lot of green shoots out there.
Q: One final question. Investors are trying to navigate these troubled market conditions and stick to their long term objectives. As an investment professional, what are some of the ways you are trying to stay rational and patient through these difficult periods?
Miller IV: I look across the markets and say, okay, what has to occur for these numbers or implied expectations to be true, to make these prices make sense, or these kind of relative values actually be rational and right. Looking at it now, I think that a lot of this just doesn’t make any sense. When you see that, the probabilities across the market signals are just way out of whack. It is frightening at times, and that’s reflected in a lot of volatility. But understanding what the numbers actually mean and how some of the logic just can’t flow, that makes me feel better.
(Comments from 3/13/20)
Bill Miller and Samantha McLemore: Market Uncertainty over Coronavirus
Bill Miller IV: Finding Value in Debt of Secular Decliners
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