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Third Avenue Focused Credit Tackles Distressed Debt

Summary TFCVX targets stressed and distressed securities, with more than half of the portfolio classified as “special situation”. Active management is a must in this area. The fund currently yields more than 10%. Third Avenue Focused Credit (MUTF: TFCVX ) is an aggressive high-yield bond fund with a focus on stressed and distressed securities. The fund seeks to deliver total return, not current yield. Strategy TFCVX’s strategy rests on what the firm calls the “Fulcrum Security…the most senior security that will likely convert into equity ownership in a restructuring.” Managers look for discounted debt securities that stand a good chance of being paid at par value in cases where the firm’s fortunes turn around, or stand a good chance of being converted to equity in a restructuring. They shy away from holding the highest-yielding debt in a company, since that debt could expire worthless, but they will also shy away from the lowest-yielding senior debt, since it doesn’t offer as attractive a yield. The fund’s sweet spot are the securities that turn into equity in a restructuring. Profit mainly comes from one of two paths: collect hefty coupon payments and see some gain on the principal, or get a controlling interest in a company as it emerges from bankruptcy or restructuring, with the opportunity for even larger upside. The big risks inherent in the strategy comes from the fact that it’s impossible to know which security will be the “Fulcrum Security” ahead of time, along with the difficulty in estimating the future value of a firm post-restructuring. Additionally, the fund is dealing in sometimes illiquid securities or opaque situations, such as a bankruptcy fight in court. Lead manager Tom Lapointe was named a 2014 Rising Star of Mutual Funds by Institutional Investor. He previously served as co-head of High-Yield Investments for Columbia Management. Portfolio As of December 31, TFCVX had $2.37 billion under management. The fund is fairly concentrated for a bond fund, with only 86 holdings. The top ten holdings accounted for 38.3 percent of assets . (click to enlarge) One of the portfolio statistics that sticks out is the $76.01 average price of securities in the fund versus the par value of $100, highlighting the fund’s ownership of distressed securities. Only 18.9 percent of the portfolio was in performing securities, with 51.7 percent classified as special situations. While TFCVX has a high yield today, the fund’s mandate and stated strategy targets total returns, which could involve holding non-income paying equities received as part of a restructuring. There is no guarantee of income, and income could decline substantially if bankruptcies increased and the fund converts debt to equity. Payouts have been in a general uptrend since inception in 2009, but this a period when the market for high-yield debt improved, allowing firms to restructure debt without declaring bankruptcy. Were there to be a period of economic stress or a deep recession, more of the fund’s holdings may become special situations, with debt converting into equity, lowering income payments. The fund’s mandate requires it to hold 80 percent of assets in credit instruments. Under the guidelines of this mandate, equity and convertible bonds acquired as part of a restructuring will be classified as credit instruments. Equities are currently only 13.7 percent of assets, but this could rise substantially under the funds mandate, materially impacting the fund’s yield. In a period of relative tranquility for high-yield debt, TFCVX has a 3-year standard deviation of 7.40 versus 4.83 for the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) and 2.85 for the Barclays U.S. Aggregate Bond Index. TFCVX has a 3-year beta of 0.01 versus the Barclays U.S. Aggregate Bond Index. HYG has a beta of 0.57 versus the same index. Compared to the Credit Suisse High-Yield Index, TFCVX has a beta of 1.16. The fund is volatile and correlated with high-yield bonds, but is less correlated to the overall bond market than other high-yield bond funds. TFCVX In A Nutshell This bit from the October 2014 shareholder letter shows why investors interested in the distressed debt market would do well to invest with capable managers (emphasis mine): We initiated a position in Ideal Standard in December 2013 at a 70% discount to where Bain had invested. We were able to accumulate 25% of the notes that we believed would be (and in the end were) the fulcrum (11.75% EUR Senior Secured Notes), buying from investors selling off the company on liquidity concerns. Up until this point this was a fairly routine investment. Complications started when the company went into reorganization and initiated an exchange offer that did not allow minority note holders, such as Third Avenue, to participate in the equity, and intended to leave us with a high-yielding fixed income instrument only. We contested this exchange offer and threatened a legal action in the US. This gave us leverage; we were able to negotiate revisions to the exchange offer that allowed us to get a 20% stake in the equity. The restructuring was completed in spring 2014. The recapitalization values the company at $500 million today. We believe this investment, a 2.1% position in the Fund as of October 31, 2014, has significant upside and limited downside. Investing in distressed debt requires a lot of homework, but even if an investor finds an undervalued security, courts and lawyers may change the facts on the ground. Small investors are unable to influence this process, but fund managers can and do influence these situations in favor of their investors. Managers are also able to grab opportunities that small investors cannot access. In another example from the shareholder letter , the fund made a bridge loan to a firm in distress, an investment opportunity that small investors cannot access on their own. Performance Warren Buffett famously said that the market was a voting machine in the short term, but a weighing machine in the long term. Third Avenue Focused Credit is a perfect illustration of this maxim at work because managers of TFCVX are engaged in long-term investments in distressed credit, but the securities they hold are subject to daily pricing. Since the outcome of distressed credit is highly volatile, with a high probability of bankruptcy, pricing of securities will be volatile. Even if investors have a high risk tolerance, they also need a long-term outlook in order to profit from the strategy employed by TFCVX because managers need time to unlock the fundamental value in these securities. As the case of Ideal Standard shows, it was not timing or even fundamental analysis that ultimately turned the position into a winner, but the threat of legal action. The value of securities held by TFCVX may be in “limbo” at times due to outstanding court cases and legal claims, leading to wild price fluctuations. Market prices for the debt held in TFCVX may deviate substantially from the underlying value, particularly when the resolution is unclear and the broader market is experiencing a bout of fear. The high-yield debt market is currently experiencing some risk aversion and the recent drop in TFCVX has led it to underperform the iShares iBoxx $ High Yield Corporate Bond ETF. (click to enlarge) The underperformance is due to the past seven months of turmoil in the high-yield debt market, influenced by the plunge in oil prices. To give a little clearer picture, in this chart, the red line represents the price ratio between HYG and the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ). A rising line indicates HYG is outperforming. (click to enlarge) TFCVX is more sensitive to changes in investors’ risk appetites. Investors have gravitated towards investment-grade bonds and U.S. Treasuries over the past seven months, and the riskier TFCVX has suffered as a result. Fees And Expenses TFCVX has an expense ratio of 1.16 percent, which includes a management fee of 0.75 percent and a 12b-1 fee of 0.25 percent. This is a high fee relative to the high-yield bond category, but is not excessive considering the specialized nature of the fund. There is also a 2 percent short-term redemption fee on shares held less than 60 days. Conclusion TFCVX is a high-risk, high-potential reward fund. The fund opens a part of the debt market that is largely closed to small investors, one that can deliver attractive returns over the long term and add some diversification to an already well-diversified portfolio. Investors interested in TFCVX must be ready to sit through volatility. Many funds have short-term trading fees in order to reduce volatility, and TFCVX is no exception, but the negative effect from share redemptions would be amplified during a liquidity crunch in the high-yield bond market. Investors who are not comfortable with a long-term buy-and-hold approach would be better off in a more liquid high-yield bond fund. For those investors looking for total return and capital gains, TFCVX is a unique fund worth considering. The recent drop in price presents a good entry point for long-term investors. TFCVX has suffered due to risk aversion in the bond market, but the fund will rebound when demand for high-yield credit recovers. (click to enlarge) Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

This Is How You Invest In Oil Right Now (Without USO)

Summary Many investors are making big bets on oil since it bottomed last month. However, the oil futures curve is in extreme contango, making ETFs like USO and USL very costly. Until the curve flattens, non-integrated oil drillers are a much safer play. This article presents a dynamic model for oil investing to better capitalize on an oil turnaround. Note: This article originally appeared on Hedgewise in October 2014. It has been updated with additional data and republished. Introduction Just about everyone is betting on an oil turnaround sometime soon and trying to figure out how to capitalize on it. Unfortunately, most instruments that provide exposure to oil prices are riddled with high long-term holding costs. One of the most popular oil ETFs, The United States Oil ETF (NYSEARCA: USO ), often suffers from paying high premiums on futures contracts (called “contango”). As you can see here , these costs are particularly severe right now. Investing directly in companies which drill, distribute, or sell oil is a reasonable alternative, but these companies often fail to track the spot price of oil very closely. For example, in 2008, when oil went up 200% , Exxon Mobil (NYSE: XOM ) was only up 88%. This article breaks down the nature of this problem, and presents a dynamic methodology for investing in oil that seeks to avoid these pitfalls. A back-tested simulation that applies this logic can be seen in the graph below, under the label “Dynamic Oil Portfolio.” This portfolio is a rule-based index that invests in a single oil futures contract when the market is in backwardation, or a non-integrated oil company ETF when it is not. It significantly outperforms a long-term investment in USO, and has drastically outperformed in the last few months. This methodology can be applied to any portfolio by keeping track of current market conditions, and then choosing the appropriate ETF (or futures contract) accordingly. Comparison of the WTI Oil Spot Price, USO, and the Dynamic Oil Portfolio, May 2006 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance, Hedgewise Internal Research The Problem First, it is worthwhile to do a quick review of the problems with investing in oil. The most direct way to invest is with an oil futures contract, which commits you to buying oil at an agreed upon price at some point in the future. Unfortunately, much of the time there is a premium on the price of oil futures, called “contango,” because people are betting the price of oil will go up. For example, say the current spot price of oil was $50, and you could buy a futures contract for next month at $55. If the price of oil were to stay exactly flat for the next month, you would probably lose about $5 on that contract. If this were to keep happening, you would lose about 10% per month for the entire year! How This Applies to Oil ETFs The effect of this problem can be seen by examining the performance of ETFs that specialize in trading oil futures contracts. For example, USO has a policy of rolling over the nearest oil futures contract every month. This results in significant cost whenever the market is in contango, which explains its underperformance over time. The iPath S&P Crude Oil Total Return ETN (NYSEARCA: OIL ) and the United States 12 Month Oil ETF (NYSEARCA: USL ) are affected in a similar way. Performance of USO, OIL, and USL vs. WTI Oil Spot Price, December 2007 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance You might notice that USL has performed the best. This is because USL invests in 12 different futures contracts at all times while OIL and USO only invest in the futures contract of the nearest month. This has helped to avoid some of the dramatic costs of trading futures in periods of heavy speculation, such as early 2009. However, it is not enough to avoid the problem altogether. Still, the relative performance of USL provides an important insight. Since different oil futures contracts trade at different prices, there is an opportunity to pick the cheapest one at any point in time. This is the mandate of the PowerShares DB Oil ETF (NYSEARCA: DBO ), and, in theory, should lead to improved performance. Unfortunately, in practice, it has not. Performance of USL and DBO vs. WTI Oil Spot Price, December 2007 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance The main reason that DBO has failed to outperform USL is because of the consistency of the futures curve. It is often upward sloping over time, such that the adjusted cost is about the same no matter which contract you buy. It is helpful to zoom in on different time periods to get a better sense of how this works. You might have already observed how well DBO and USL performed from January 2008 to January 2009. We can examine the futures curve over that time period to understand why this was possible. Note that a “2-Month Oil Futures” contract is one that expires 2 months from today, and a “4-Month Oil Futures” contract is one that expires 4 months from today. If the “4-Month” price is higher than the “2-Month” price, this indicates that the market is in contango. WTI Oil Spot Price vs. 2-Month and 4-Month Futures Contract Prices, January 2008 to January 2009 (click to enlarge) Source: Energy Information Administration The important observation is how close the price of both futures contracts was to the spot price over this entire period. In fact, at some points, the price of the futures contracts was actually below the spot price, which is a case of backwardation. This allowed USL and DBO to outperform. However, this trend changed dramatically in 2010. WTI Oil Spot Price vs. 2-Month and 4-Month Futures Contract Prices, January 2010 to January 2011 (click to enlarge) Source: Energy Information Administration Here, the futures curve was upward sloping, with the price of the 4-Month contract consistently above that of the 2-Month contract. As a result, all of the ETFs involved in trading oil futures suffered. This demonstrates the general point that if you are going to get oil exposure using futures (whether directly or via ETFs), you need to be constantly monitoring the futures curve and adjusting accordingly. When the curve is upward sloping, trading futures will cost a hefty sum over the long term. Unfortunately, this has been the case about 60% of the time over the past decade. Thus, it is necessary to identify alternative ways to get oil exposure, such as investing directly in individual companies. Investing Directly in Oil Companies The most obvious candidates for direct investing are the two largest energy ETFs, the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) and the Vanguard Energy ETF (NYSEARCA: VDE ). Both ETFs invest in most of the biggest energy companies in the world. Performance of XLE and VDE vs. WTI Oil price, June 2006 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance This performance is not terrible, but there is a great deal of tracking error. While in this period the overall effect has been positive, it could just as easily have been negative as it was from 2008 to 2009. The nature of this tracking error can be traced back to the fundamentals of the oil market. First, most large energy companies are grouped into the ‘oil & gas’ sector. This is because natural gas is often found alongside oil, and comprises a significant part of their business. However, the price movements of natural gas are often uncorrelated to the price movements of oil. Second, there are three main functions in the oil industry. Exploration and drilling Equipment and transportation Retail sales Many of the big oil players are involved in all three functions, but equipment, transportation, and retail sales don’t really depend on the current price of oil. For example, if you are selling oil equipment, you would not expect short-term oil fluctuations to change your sales outlook. If you are a gas station, you receive a small mark-up on the price of oil after buying it wholesale. Only exploration and drilling companies (a.k.a., ‘non-integrated’ oil companies) have very direct exposure to oil prices since they are the ones who actually own the oil fields. The good news is that there are ETFs which track these non-integrated oil companies. Two of the largest are the iShares U.S. Oil & Gas Exploration & Production ETF (NYSEARCA: IEO ) and the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA: XOP ). Performance of IEO and XOP vs. WTI Oil Spot Price, June 2006 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance Surprisingly, these stocks actually have an even higher tracking error. To understand why, we have to take a look at the largest actual holdings within the ETFs. XOP primarily invests in smaller-sized owner-operators of oil fields, such as Magnum Hunter Resources Corp. (NYSE: MHR ) and Western Refining, Inc. (NYSE: WNR ). Performance of MHR and WNR vs. WTI Spot Oil Price, June 2006 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance The problem is that these small companies are hugely susceptible to swings due to idiosyncratic factors, like their recent discoveries and the prospects for their particular oil fields. As such, they are fairly uncorrelated to the price of oil. It makes more sense to focus on companies which are diversified across many oil sources rather than only a few, which is the focus of IEO. Two of their biggest holdings are the Anadarko Petroleum Corporation (NYSE: APC ) and EOG Resources, Inc. (NYSE: EOG ), both big drilling companies. Performance of APC and EOG vs. WTI Spot Oil Price, June 2006 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance There is still company-specific variance, but it is muted because these companies are better diversified. Because of this, IEO is likely a better play on oil exposure than XOP. However, it remains unclear whether IEO is a better option than the bigger ETFs; XLE and VDE. Unfortunately, there is no way to make a determination on numbers alone. All three of the ETFs hold oil companies that also invest in natural gas. Each of those companies will have independent factors that affect it year to year. It seems logical that non-integrated oil companies would be more directly exposed to fluctuations in the oil price than the bigger players involved in equipment, transportation, and retail sales. Yet, their relative performance suggests the difference thus far has been pretty negligible. All three are probably reasonable alternatives when the futures market is in contango. Performance of IEO, XLE, and VDE vs. WTI Spot Oil Price, June 2006 – February 2015 (click to enlarge) Sources: Energy Information Administration, Yahoo Finance How to Apply the Model The outcome of all this logic is relatively simple. Invest in the cheapest futures contract (optimizing between USO, USL, and DBO if using an ETF) when there is a downward sloping futures curve, and use a general energy ETF like IEO, XLE, or VDE otherwise. While this requires a little extra work, it may drastically reduce the costs of investing in oil over the long run. We’ve also made this a little easier for you by tracking the current state of the futures curve and its estimated impact on each ETF (linked above). Though the outcome of this model is not perfect, it is certainly more compelling than many of the alternatives. Disclosure: Hedgewise is an Investment Advisor that helps clients implement custom strategies like the one described in this article inexpensively and tax-efficiently. This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. To the extent that any of the content published may be deemed to be investment advice or recommendations in connection with a particular security, such information is impersonal and not tailored to the investment needs of any specific person. Hedgewise may recommend some of the investments mentioned in this article for use in its clients’ portfolios. Disclosure: The author is long IEO, XLE. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

PIMCO Total Return Gets Its Mojo Back

PIMCO has been in the news for all the wrong reasons lately, after more than $100 billion of clients money followed Bill Gross out of the door. But come early February there are signs the bond giant is getting its act together. While former CEO Bill Gross has moved down the street to run a new (much smaller) bond fund at Janus Capital Group Inc (NYSE: JNS ), his old fund – PIMCO Total Return Fund (MUTF: PTTRX ) – is doing just fine without him. The fund is performing so well in fact, that Morningstar has reinstated PTTRX with its coveted five star rating – the highest rating possible. PTTRX lost its fifth star at the end of 2013 following a long period of underperformance, caused by Gross betting the house against Treasuries in 2011. Gross was so sure Treasuries would fall he sold the entirety of PTTRX’s holdings, while using derivatives to bet against them. His bet was way-off, Treasuries went on to become one of the best-performing asset classes of the year. The result was PTTRX rankings plummeted to No. 87 in its category for 2011. They recovered in 2012 when PTTRX placed 12 – but the recovery didn’t last long. Gross’s mistimed call on equities meant PTTRX came in at Nos. 60 and 71 for 2013 and 2014, respectively. That patchy performance caused investors to start abandoning the fund long before Gross decided to quit. By September 2014 (Gross’s last month in charge.) PTTRX had suffered 16 consecutive months of outflows. At its peak in May 2013, PTTRX had assets of $290 billion. By the time Gross left, assets had fallen to $220 billion. In the wake of Gross’s departure, investors withdrew another $85 billion. But far from being the end of PTTRX, its trio of new managers have returned the fund back to winning ways. So far this year PTTRX has returned 1.45%, beating the Barclays U.S. Aggregate benchmark by 0.38 percentage points. While Morningstar ranks it at No. 6 in its category, beating 95% of its competitors. Despite the turnaround, investors are still abandoning the fund, with a reported $11.6 billion of outflows in January, leaving it with assets of $134.6 billion at month’s end. Sarah Bush, a Morningstar analyst, predicts the fund will continue shrinking through the first half of 2015. She believes that some institutional investors didn’t pull out of Total Return right away because they wanted to take some time to research comparable funds. Gross’s new fund on the other hand is still finding his footing, his new Janus Global Unconstrained Bond Fund (MUTF: JUCIX ) – ranks 80th in its category with a year-to-date return of -0.08. Indeed, JUCIX is lagging the bond benchmark by 1.15 percentage points. With the WSJ reporting that inflows into his new fund fell to about $86 in January, the lowest amount since Gross took over running the fund in early October. JUCIX has net assets of $1.5 billion, of which approximately $700 million comes from Bill Gross’s own account.