Leveraged Loans: Ready for Lift-Off Says Steve Tananbaum of GoldenTree Asset

	Monday, April 21, 2008

By LAWRENCE C. STRAUSS STEVE TANANBAUM'S ROOTS ARE IN HIGH-YIELD BONDS, which he began analyzing at MacKay Shields in 1989. He became head of the department two years later, while still in his mid-20s. Since then his horizons have expanded to all sorts of asset classes, including equities. No surprise, he remains a value investor. Eager to run his own firm, Tananbaum left the mutual-fund world in 2000 and launched GoldenTree Asset Management. With nearly $14 billion in assets, much of it in hedge funds, the New York firm devotes a lot of its time and energy to alternative assets. One of Tananbaum's favorite investment themes right now is bank loans used to fund leveraged buyouts. Amid the credit crunch, which has caused the spread between yields on high-yield bonds and Treasuries to widen, these loans have come under pressure. This kind of debt isn't widely available to retail investors, though some mutual funds, such as Eaton Vance Floating Rate1 Fund (ticker: EVBLX) and AIM Floating Rate2 Fund (AFRAX), specialize in bank loans. Steve Tananbaum So-called loan-participation funds haven't done well lately, and are down about 4% year to date through April 14, according to Lipper. But that's better than the broader market's total return of minus 9%. GoldenTree's flagship offering, the $5 billion Master Fund I, which looks for value in equities and bonds, was down 5.39% in this year's first quarter, but more than two percentage points ahead of the Merrill Lynch high-yield credit index that's used as a benchmark. The fund's five-year annual return of 11.34% bests the high-yield index by nearly three percentage points, as of March 31. Barron's recently caught up with Tananbaum, 42, at his midtown office, which houses a portion of his art collection, including the spacesuits by artist Tom Sachs shown in the photo at right. Barron's: What is happening in the credit markets, where conditions since August have been very tough? Tananbaum: The credit problems that started last year, and which were perceived to be isolated, really spread throughout the system. In different pockets of credit, things were mispriced. Right now you're seeing a repricing of credit. Whereas last year you were being underpaid to own credit, now you are being overpaid. You mean, in terms of much wider spreads? That's right. Against that backdrop, the investment banks have been damaged. Normally they provide credit to the financial system. But things aren't working the way they normally do. You're seeing the banks' inability to provide credit to a lot of their corporate customers. Are the banks lending less because they have to put more of assets on their balance sheets? The banks are playing defense. They are more worried about their current relationships than beginning new relationships. Are hedge funds paying higher interest rates to borrow from banks? The terms are different from what they were six months ago. The banks are looking to provide less leverage at wider spreads, and only on larger pools of assets. How has that impacted GoldenTree? First of all, most of the money we run isn't levered. We have about $10 billion of alternative assets, of which $7 billion to $8 billion doesn't have any leverage associated with it. Also, we have favorable terms, with four to five years left on our credit facilities, so nothing is coming due right away. Having said that, if you have access to borrowing money, then bank debt, or leveraged loans, is very attractive. That's because the spreads on bank debt have widened considerably, to somewhere around 600 basis points [six percentage points] above Libor [the London interbank offered rate], meaning the prices have come down significantly. Those spreads are as wide as they've ever been. In the next two years, you could see spreads going back down to 400 basis points. That would give you double-digit returns over the next two years. So this is a good time to be buying? This is a great opportunity to be buying. It reminds me of earlier credit crises, such as the ones involving Mexico in 1994 and Russia in 1998, and the one that unfolded at the end of 2000. It was clear: The markets correctly predicted that defaults would pick up, and there is usually indiscriminate selling at those points. That's what we have today. But the credit market right now favors those with the money to buy. Earlier in the year, some of the easiest purchases were investment-grade names like American Express [AXP]. It had a new debt issue that was trading 362 basis points, or 3.62 percentage points, over Treasuries. That's what the high-yield index was yielding about a year ago. Now that debt's spread is in the mid-200s above Treasuries, meaning the price has appreciated. But there was definitely a disconnect. What was driving bond prices to such low levels? Leverage was a big part of the story. The first phase, as I said, was indiscriminate selling, much of it driven by a lack of liquidity. A lot of people had taken out lines of credit, leveraging up in some cases on bank debt, or loans used to finance buyout deals. When the value of the bonds went down, say 10 points, these investors got margin calls and were forced to liquidate, because they couldn't come up with any equity. It was basically a bunch of margin calls in February, and then in March it became a systemic issue with Bear Stearns [BSC]. What is your take on Bear Stearns' collapse last month, and its pending acquisition for about $10 a share by JPMorgan Chase [JPM]? The Bear Stearns situation initially was about whether fraud was involved. The market got comfortable that it wasn't about fraud, but more about Bear not having the right capital structure. Then there was a run on the bank. The market has gotten healthier since the Bear episode, and the Fed has done a terrific job providing liquidity and telegraphing they intend to provide more. What's the next step in the credit markets? On the debt side, it's about finding companies whose balance sheets work. By that I mean which companies are self-sustaining in the current environment, as opposed to which balance sheets potentially are at risk of defaulting. The debt of Calpine [CPN], which has emerged from bankruptcy protection, was a large holding for the investment banks. Calpine had too much debt. But now, after the restructuring, it's a healthy company. The leveraged loans of Clear Channel Communications [CCU], the radio and entertainment company whose buyout has been stalled, could be a more challenging investment. Table: Tananbaum's Picks…3 Do you hold Calpine bank debt? Yes. On the bank-loan side, we are focusing much more on companies where we are at the top of the capital structure. Calpine and TXU Energy, the Texas utility taken private last year, are interesting loans. What does it mean to have a good position in a company's capital structure? It means you get paid before others if things go wrong. You're first in line, ahead of the common equity holders. As investment opportunities, how do you view junk bonds versus leveraged loans? A lot more leverage was used for investing in bank loans. There wasn't as much leverage in high yield. Bank debt had a lot of margin calls at the beginning of this year, creating buying opportunities. And because there was such an overhang from the investment banks that held these loans on their balance sheets, it was a more attractive market. There was no forced selling in high-yield bonds. Thus, bank debt, which is more senior in a company's capital structure, fared worse than junk bonds that were more junior. Bank debt offers better relative value than high-yield bonds. What is on the horizon for bank debt? April is starting off terrific, but there will be twists and turns. At the end of the day, what is going to determine returns, whether for high-yield bonds or leveraged loans, is the performance of the company. When certain companies can't grow into their balance sheets -- they can't, in effect, make their debt payments -- that's going to create opportunities, as well. Any examples? First Data, a financial-services company that helps process credit-card transactions, comes to mind. They were taken private last year. They have a big capital structure, and it will be hard for them to pay off debt. Bank loans aren't readily available to retail investors, though there are some bank-loan mutual funds. Let's talk about some themes that have a wider appeal. We've always looked at arbitrage between the public and private markets. In equities, there was a big discount to the private-market values of deals. That's opened up some terrific values because there is no private-market value right now. Many companies, including some in the media industry, traditionally were valued off of private bids. Now, in many cases, there is no private- market value because deals can't get done. Some argue it's still too early to get into bank debt. Should you wait? It depends on the situation. If you're talking about retailers or home builders, absolutely, it's early. We are avoiding home builders and retailers. The bonds of home builders, particularly the investment-grade issues, look extremely rich. But that's not true of all industries. Some bank loans related to utilities look attractive. For those companies, it depends on the dynamics of the region a utility is operating in. Tell us about some equity holdings. The television market in general has very good fundamentals. This is a presidential- election year, and the expectation is this will be the biggest spending year ever for TV broadcasting in terms of advertising. We are long the equity of Sinclair Broadcasting Group [SBGI], which owns a string of television stations around the U.S. It's a well-managed company with strong free-cash flow. And they have been benefiting from retransmission. Which is? Basically, getting fees from cable companies for their stations. We also like some cable companies, including Time Warner [TWX]. These companies have always traded at discounts to their private-market values. But we expect them to have high-single-digit cash-flow growth this year. Warner has a catalyst, given that [President and Chief Executive Jeffrey] Bewkes has telegraphed he's going to be splitting up the company. Time Warner trades at a significant discount to what we think its intrinsic value is, and it doesn't have a lot of debt. We believe, whether it's through dividends or buying back shares, they are going to releverage their balance sheet. Time Warner and other cable companies are pretty much going to deliver the growth rates they've achieved over the last 10 years, yet their valuations are around 40% of what they've been historically. As recently as six months ago, these cable companies had double-digit multiples, based on earnings before interest, taxes, depreciation and amortization. And you can buy them for roughly half that now. Any other thoughts on the cable industry? We like international cable a lot. There's less competition overseas and we feel good about earnings. Liberty Global [LBTYA], is our largest holding. Where else do you see value? With casinos, take a look at MGM Mirage [MGM] compared to Harrah's Entertainment [HET]. Recently you could buy the debt of Harrah's, which has a better collection of assets, yielding close to 15% and trading at six or seven times cash flow. At the same time, MGM's equity was trading at about 10 times cash flow. We felt Harrah's debt was a better buy. We were short some MGM equity earlier this month, given that growth in Las Vegas is under some pressure in this economic environment, but we covered after the shares went down. MGM is a terrific company, but it turned out to be a good short for us. Thanks very much, Steve.