Monday, September 04, 2006


Alas, this is not a great time to be a high yield bond salesperson. If you work at one of the big shops, you have suffered new issue spreads compressing steadily over the years. Newbies listen in awe and envy as old-timers talk about the days of 3% and 4% underwriting spreads. And since each deal now seems to have at least 2 bookrunners and 5 co-managers, your slice of the pie has gotten much smaller. And the Man Upstairs is clamoring for a bigger return on the huge amount of resources that he has poured into this stinkin' business over the past 10 years, and so your ultimate payout rate has shrunk to the single digit percentages.

Matters are even worse at the commission shops. The days of the non-risk, high payout commission bucket shops are numbered. 2003 was the last hurrah. The model is broken, defunct. Trace has crushed the margins and credit default swaps have clipped the volumes. Panic has given way to mass depression. Among the smokers puffing outside office buildings, you can occasionally spot one or two high yield salespeople, hyperventalating and sweating, filled with dread and anxiety. Time to say goodbye to the au pair....Omigod!!! So long Mercedes and hello Maxima.

The old joke that once made the rounds was, "If I die and can be re-incarnated, I want to come back as the wife of a high yield bond salesman." Those were the days, my friend, we thought they'd never end. Now such a wife greets her hubby every evening clutching unpaid bills and shrieking about her beloved credit card being maxed out.

The Great Shakeout has started and is on-going. Classical economics are at work as excess capacity is being drastically reduced. There were way too many shops and bodies in this business 3 years ago. At one time, there was close to 50 outfits involved one way or another in selling high yield, or about 1 for every 6 accounts. The time has come for people to leave the business. The Exodus is here.

But what's a poor bond salesman to do? Send his resume to the post office? Afterall, what outstanding qualities can the typical salesman claim? A great phone voice? An intimate knowledge of Manhattan's best restaurants that rivals Zagats? The more daring and ambitious sellside individuals are thinking bigger than that. The real dreamers are looking to go buyside.

Any sellsider who has spent much time around buysiders knows that to cross the street really doesn't take such a great leap of faith. When you get down to it, buysiders aren't any smarter than the sellsiders. Maybe they work their way around EXCEL better and usually have a higher geek factor, but that's about it. They got onto the buyside years ago when the money was on the sellside. The opportunities for nerds with accounting majors were somewhat limited at the time. So guys like that became analysts. And after years of keeping their heads down and avoiding mistakes, the natural river flow landed them in a PM position. And now the tide and tables have turned, and the little nerd thinks he's a master of the universe.

Okay, say you are a sellsider and want to get to the buyside. Where do you start? First of all, you angle for the hedge funds. Forget mutual funds or insurance companies, since there's no money there. Okay, hedge what? If you work for one of the bulge bracket, new issue shops, you might consider marketing. Let's face it, a new issue salesman is not much more than a glorified travel agent whose main function is to make sure accounts know what the road show schedule is. Second to that, his talent skills most match that of a maitre'd.

But maybe you think of yourself as a "research salesman." A guy with a brain who can read a 10K as well as any analyst or PM. You actually know that EBITDA stands for Earnings Before Interest Taxes Depreciation Amortization. Ta Da! Welcome to the buyside.

So let's speed things up and say that after keeping your ears to the track and your eyes on the horizon, that old college buddy/drinking partner/wing man starts up a hedge fund and you bamboozle him into thinking you know something about high yield and how to manage money. And for kicks and giggles, he hires you. Now what? First, what's your goal? That's easy. Your goal is the same as everyone else who works at a hedge fund, ie, make as much money as quick as you can. Rake it all in with both arms. We all know that the market is stretched, that spreads are as tight as they are going to get, that the top is in place. The only question is, when will the real dizzying descent begin? Next year, 08? Safe money says that sometimes over the next 2 or 3 years the market is going to crack and tank, maybe even crash. After that, the jig is up. The 20% incentive fee, profit sharing bonus, or whatever else you want to call highway robbery, will be a moot point because no one will ever be able to get back to that "high water mark" reached in Febuary of 07. Here's to living on a 1% management fee...and that can be a pretty good living but it ain't master of universe pay. In summary, get it while the gettin' is good.

Now that you have fixed your goal, what should your strategy be? To have a strategy, you first have to understand your client who has invested in the hedge fund. Your strategy has to fit the investment parameters of your investors, who are typically endowment and pension funds, or high net worth individuals. As different as they are in many respects, these investors share one common trait: They are dumb money. Think about it. How smart can you be to hand millions upon millions over to some guy who asks that he be paid 1% for doing nothing, as a management fee, to cover his office expenses? (The truly audacious ask for 2%.) And then on top of that, he wants 20% of the gain. All this for a track record of generating mid single digit returns. My money market accounts gives me 5% and I'm not giving up 21% of the juice to get that! I'm willing to bet a lot of money that Warren Buffet has no money in a hedge fund that asks him to pay 1% for the honor and then give up 20% of the take. That is plain stupid.

And of all the dumb money, high yield money is the dumbest. Well, maybe it's not so much dumb as "forced." Some investors, like pension funds, have to have some dough in fixed income, by statute or by-laws. So how are they going to allocate their fixed income money? In 10 year TSY notes yielding 4.75% or investment grade bonds 100ps over that? Such investors have no choice but to put some money in high yield bonds. And the beauty of it is that they expect so little. All they ask of you is that you make the coupon. That's it. You don't have to give them a big return...just give them a damn coupon. Hell, that's not much of a hurdle to jump over. About as easy as jumping over a crack in the sidewalk.

But the sad, sorry little fact is that so few high yield managers are able to do even that. It's one of the mysteries of the business that year after year high yield can't manage to make the coupon, and yet money keeps pouring into the sector. I saw hedgies giving high fives at the end of last year because they generated a mid single digit return, before the 20% take. And the average high yield coupon was over 7% and they think they are geniuses for making that.

Okay, so now your have your goal. The next question is, what is your strategy? You first have to determine how much risk you should take. The answer is that you take a lot of risk with investments that are very illiquid and hard to mark and very little risk with investments that are very liquid and easy to mark. And so you are willing to make that sexy private equity investment in some outfit that delivers hot lunches to crews on off-shore drilling rigs because you know that no one will ever have a clue how to value it; and there is a 1 in 4 chance that it could be a home run, even a grand slam. And what if it isn't, what if it goes bust? Well, that'll be at least 3 years down the road and by then you will have pocketed enough dough from your dumb money investors that you won't have to worry about it. You can leave them holding the shit bag. That's what "side pockets" are for, a place to hold the the investments that could either be turds or bricks of gold.

As far as investments that are easy to mark, the rule is to keep it simple and safe. Remember, your investors just want you to make the coupon. You can swing for the fences on private equity investments, but when it comes to tradeable bonds you just cover your ass, cover the coupon. And how do you do that? You play the new issue game, that's how.

Playing the new issue game means that you try to get in as many new issue deals as you can and you flip them once the price reaches somewhere between 100 1/2 and 101 after the break. Almost all deals trade up to at least that level after the break because the underwriter is willing to spend a little capital to make the deal appear like a success. Usually that capital runs out around 100 1/2 to 101, no matter how crappy the deal. So forget about spending a lot of time and effort on due dilly. Just close your eyes and throw darts at the new issue calendar. Sure, there's a chance the dart will land on one of Jeffries stinkers, but more than likely your random action will pay off.

The main risk that you run is that you become labeled as a "flipper" and your allocations become de minimus. You can avoid that by using the plethora of commish shops that are dying for biz and, like sucker fish sticking to a shark, look to the new issue flipping as one of their main sources of revenue, as pathetic as that is. If you are clever, the underwriters will never know that you sold your bonds to Miller Tabak.

And so you keep the wheel spinning, playing new issues and flipping out of them. That strategy enables you to maintain a return at least equal to whatever the market coupon is and gives you some vig when you flip at 101. Easy as apple pie.

And so after a few years, you have kept pace with the market and one or two of those private equity deals have paid off so that the 20% performance fee actually means something. And what do you do when the shit finally hits the fan and the markets fall out of bed? You go back to the sellside, of course, and trade distressed. Trading those triple hook deals that came with a single digit coupon will be a blast.

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