New York-based Phoenix Investment Adviser is a credit hedge fund manager with $275 million under management. The firm’s JLP Credit Opportunity Fund was recently ranked first in the distressed securities space by BarclayHedge (with a three-year compounded annual return of 26.9% from 2008-2010).
Phoenix specializes in the long stressed bonds of U.S. companies—particularly those bonds trading at under 75 cents on the dollar. This market, which peaked at around $500 billion during the economic turmoil of 2008, has since returned to its pre-crisis dimensions. But it still holds potential, according to Phoenix founder and CIO Jeff Peskind. He spoke to FINalternatives’ senior reporter Mary Campbell recently about the ins and outs of investing in this bond market niche.
In May 2010 you gave an interview in which you said we were in the ‘sweet spot’ of credit cycle—how would you describe situation today?
As we sit here in February of 2011, I think we’re starting to get into the middle to later innings of the credit cycle, meaning that credit spreads have tightened pretty significantly since May of 2010 and the average dollar price of junk bonds is north of par—they’re actually trading around 103 today and the spread is down to about 450-460 basis points over the U.S. Treasuries so, I think pretty much the easy money has been made in the high-yield market at this point.
Phoenix’s niche market is bonds trading below 75 cents on the dollar – what’s that market like now?
That market has also gotten a little bit tougher to find bonds in our niche – we calculated at the end of the year there was about 30 billion dollars’ worth of bonds trading below 75 cents on the dollar, that’s kind of a normal average if you look back over the past 10-15 years, but in 2008 it was about $500 billion. So, 2008 was the best time ever to be looking for bonds in our niche. Today, at $30 billion, it’s back to being a kind of normal environment...you’re really going to have to generate superior returns by picking the right bonds. But again, our fund, because of our size, at about $275 million, we’re still finding good value.
I’ve read that you reject 90% of the issues that trade in your niche space – was that true even in 2008? Given that you’re only really interested in investing in 10% of that market, how do you choose the bonds you invest in?
We have a rigorous investment process that really is trying to identify the bonds in our niche that are not going to go bankrupt...We look really at three things: number one is liquidity of the company, number two is to make sure that the covenants in all of the loans are not going to be violated, and then lastly, are bonds that we’re buying trading in the open market below what we think the intrinsic value is? And that process eliminates the vast majority of bonds that we look at—[historically] nine out of 10 of the bonds we look at don’t meet all of those criteria. But in 2008…we were looking at a lot of bonds that were meeting our criteria. Just about anything we bought in 2008 met all of our criteria.
Are there any industry groups you currently consider to be under-valued?
Well, again, we don’t really look at industry groups, we’re more kind of bottom-up focused, so we’ll look at [the] bonds [that] are in our space, but the one area that is the most attractive for us right now is the paper sector....The paper sector seems to be the one industry group that [has] lagged the rebound in the overall credit space. I think that’s due to the fact that, the sector outlook is not great, and people just don’t spend a lot of time looking at industries without great long-term fundamentals, but we think that’s right now where the best value is.
Is this a research intensive investment strategy? Do you have a large research department? Can you give me an idea of how you go about researching a potential investment?
This is a very research-intensive process. We really have to look at a company’s prospects and really tear apart the balance sheet to make sure that nothing trips up the company and forces them to go into bankruptcy. We have five full-time research analysts broken out by industry, all with significant experience looking just at this niche of companies that are stressed... And the way the process works is, we simply wait for bonds to fall in price, that’s the first part of our process, so we screen out the universe by making sure that the bonds are already trading at a big discount to par, then we assign them to one of the five analysts and they will spend usually a couple of weeks looking at the companies, modeling the companies’ cashflows, analyzing liquidity, analyzing the covenants, calculating the intrinsic value and then they’ll come up with what they think the bond is worth.
Now, if we think a company has a serious risk of bankruptcy, we won’t spend any more time on it, but the companies that we think will avoid bankruptcy, we rank them internally here by their discount to intrinsic value. So, in the portfolio we’ve got about 30 different names—the universe is two-to-three hundred different names—and what we’ll do is, of our 30 names, we think we’ve identified the bonds trading at the biggest discount to intrinsic value so that gives us our best risk reward and if a bond moves up in price significantly, we’ll look to sell that and replace it with a bond trading at a bigger discount to intrinsic value. So, we’re constantly monitoring business fundamentals and revising our estimate of intrinsic value, and we’re constantly monitoring the market price of the bonds, and we’re just trying over time to re-circulate the fund into the bonds that we think give us the best risk/reward.
What role is played by institutions in this niche market? Do you count institutions among your investors?
There are some institutions that are chartered to only own investment grade bonds...The cut-off between investment grade and junk is BBB, so if a bond is downgraded from BBB to BB some people look and are forced by mandate to sell… The same thing happens in junk. If a bond gets downgraded to CCC from B, some investors go ahead and look to sell those bonds in the open market. And that’s where we step in and try to buy those bonds after some institutions are looking to sell them for non-economic [reasons]. But the vast majority of our investors are not those institutions. Our investors, primarily, are family offices, high net worth individuals and some funds of funds...although, some of our investors are insurance companies...we’re really more in the alternative space than their mainstream bond space.
You say you’re right now at $250 million and your size is an advantage. What would be the optimal size for your fund?
Yes, currently we think about $500 to $700 million is our optimal size. Again, the overall junk market is about $1 trillion (it’s grown significantly). Our niche is, $30 billion of roughly $1 trillion, so our whole niche is 3% of the overall market and at $250 million in a $30 billion niche, we’re still relatively small. But our goal is to generate equity-type returns in the bond market and we’re going to size the funds to make sure that we can achieve those goals and right now, given the size of our space, we think the fund can grow to between $500 and $700 million. At that point, if the market does not grow, we’ll look to close the fund.
If this is a cyclical market, where is it going in the next couple of years?
Right now, we’re in the part of the cycle where the default rate is really low. Moody’s put out a report, there were zero defaults in January...globally...The Fed, everyone has just flooded the markets with liquidity and just about every company we know of can refinance. So, I think over the next year or two, the Fed may start to reduce some liquidity, and we’re going to go back over the next couple of years to a more normal, 3-4-5% default rate which would mean that our niche over the next couple of years will probably grow to $40, $50, $60 billion again and that’s when it will be much easier to find good opportunities.
I think for the next couple of years [our niche] is still going to be a good place to be, at our size, because the credit cycle is so strong right now. We can find company bonds that are mispriced and the ability for them to refinance over the next couple of years is really good, this is a good environment for us in terms of what we think we can generate in returns but it won’t be that big of an opportunity set. But we think starting in another year or two there will be a lot more opportunities.
One other way of looking at it is, normally, the way these cycles work, you have a big push of new issuance—2010 and 2011 are probably going to be all-time record years for junk-bond new issuance. And normally, it takes about a year to three years for some of those bonds to start to have problems and trade down into our space. So, I would think in a year or two we’ll start to see a lot more opportunities, but our fund at our size, if you can find the right opportunities, this can be a good time to be a buyer in this overall credit environment.