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Looking for Distress

Jeremy Glaser

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I am here at the 25th Anniversary of the Morningstar Investment Conference with Tom Lapointe. He is the portfolio manager of the Third Avenue Focused Credit fund.

Tom, thanks for joining me today.

Tom Lapointe: Thanks, Jeremy. Thanks for having me.

Glaser: So, most high-yield funds really take pains to get away from distressed situations and get away from those workout situations. Your fund is a little bit different. Can you tell us bit about the strategy?

Lapointe: We really, unlike most funds, actually look for distressed investments or ones that might default. So, we find some of the best opportunities are when people are trying to run away from situations that are uncertain, might involve bankruptcy, and that's where we can get the best value.

Glaser: Right now, there is not a ton of distress in the corporate market. Profitability is pretty high. Are you finding a lot of values?

Lapointe: It's harder. It's definitely harder. I’d say when we started the Focused Credit fund four years ago, we were probably looking at two or three investments and buying one of them. Today, we're digging through 10 or 15 and buying one of them. But what's nice about the corporate space, whether bank loans, high-yield bonds, converts, or preferreds is in Corporate America, you always have defaults happening.

We have had three major cycles of defaults, but in those cycles there’ve been little mini-default cycles whether it's the theater business or some sort of cyclical industry. So, we're always finding little opportunities. Right now, [we're looking at] the steel industry, the coal industry, gas industry. So there’s always opportunities; you just have to dig a little harder right now.

Glaser: Are you expecting defaults to rise appreciably? Do you think the economy is going to get turned around, or do you expect [defaults] to remain kind of this low?

Lapointe: At the risk of making a prediction, I think defaults will probably stay low for the next two or three years, below 2%. I think the key risks today are interest rates rising and what sort of duration [a measure of interest-rate sensitivity] you have, if you have credit duration or if you have duration closer to Treasuries. I think the U.S. economy is probably doing better than people give it credit for, and I think those factors would lead people to want to be invested more and take credit risk and not foreign exchange or duration risks.

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Glaser: Let's look at some specific names that you've invested in recently and how those have worked out. How about Sprint, a telecom name that you are in?

Lapointe: Sure. We made Sprint, about a year and half ago, an investment. Sprint is a big index name that a lot of people hold, and it was trading somewhere around 6% [yield] and we generally don't buy anything in the fund that we don't think has the potential to make 10%-plus per year. So, it's income and total returns as an investment. But Sprint came into some problems about year and a half ago, and the bonds dropped from a 6% yield to like a 10% yield.

We ended up buying the longer-dated bonds that dropped to $0.70 on $1, and the problem with Sprint at the time was cash flows were falling, they didn’t have the iPhone, they had to do something with their new generation 4G network, and the market didn't view it as though they had enough money. So, we looked at the covenants, we looked at the assets of the company, whether it was the towers or the spectrum, and thought that they had plenty of liquidity available and the ability to raise liquidly. We bought the securities, made it a 3% or 4% position. A year and half later, after they had gotten through some of the problems and then Softbank came in to buy them. We sold our securities at $1.06. So we made about a 50% return.

Glaser: What about Cemex, the Mexican cement company, you had that big investment in?

Lapointe: Sure. It's a similar situation. We try to invest in companies that we understand the bankruptcy process, and so Cemex, based in Mexico, was one of those ones where we had to feel comfortable with the assets. They had plenty of assets here in the U.S., and the securities we bought would have been under New York or Delaware bankruptcy law. So, we felt comfortable with that.

We bought the securities at $0.70 on $1 when the company was going through a liquidity crisis. People didn’t know if they would be able to refinance their bank debt, but what we're looking at, not so much as yield, is the assets underlying the business. We feel they have significant assets that will cover debt either through maturity or through restructuring, and we get to own the company through a restructuring. We love those sort of investments. So, we ended up selling those at $1.11, and made about a 40%-50% return.

Glaser: Let's take a step back for a second. One of the big fears in fixed income right now is rising rates. When is the Fed going to taper [it's bond-buying program] and what’s that going to do? How do you expect distressed-type investments to perform in a rising-rate environment versus bank loans or versus other high-yield sectors that people are throwing a lot of money into?

Lapointe: Duration and interest rates are the biggest uncertainty, if you will, and whether or not interest-rates rise or not is beyond me. The average yield of our fund is over 11%. So, our spread to Treasuries is 1,000 over Treasuries. If you take the regular high-yield fund, the average spread is about 400 over Treasuries. If you back up Treasuries 200 basis points, there's no room to compress all that 200 basis points in a regular high-yield fund. In a fund that trades at 1,000 over Treasuries, 200 basis points is almost irrelevant. The concept of duration really comes into play when you take duration of 3 years for a Treasury bond and 3 years for a high-yield bond fund, they have totally different correlations to how they’ll act with interest rates rising. And if you have interest rates rising 200 basis points or 300 basis points, hopefully or usually that means that the economy is doing better, and we have inflation.

For companies that we own, stressed companies, an improving economy and some sort of inflation is a good thing for these companies. In fact, the biggest problem they have is they owe somebody too much money 10 years from now and a little bit inflation helps because if they can keep their cost of goods sold in line, their actual cash flow improves, and their interest expense doesn't and they have a better chance of staying out of bankruptcy.

Glaser: Tom, I appreciate your sharing your thoughts with us today.

Lapointe: My pleasure.

Glaser: For Morningstar, I am Jeremy Glaser.