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When Bruce Richards and Louis Hanover co-founded Marathon Asset Management in 1998, it wasn’t obvious that buying the debt of extremely stressed or bankrupt companies could be a great idea. There was just $20 billion in hedge funds focused on distressed and restructuring, according to Hedge Fund Research data.

But the two — who became friends working together at Smith Barney — saw an opening, and 20 later, Marathon is one of the biggest distressed-debt specialists. It oversees just shy of $15 billion, in what’s now a $200 billion industry. Marathon has grown to span strategies across credit and real estate. In 2016, they got a stamp of approval from Blackstone Group (BX), when its Strategic Capital Partners fund took a passive minority stake.

We caught up with Richards, Marathon’s chairman and chief executive, and Hanover, the chief investment officer, on their outlook for credit in the new year.

Barron’s: What are you positioning for in 2019?

Bruce Richards: The macro backdrop is relatively solid for 2019. Global growth is intact and trending lower. U.S. GDP growth should be either side of 2% this year, and trending lower. Earnings grew 25% last year: 15% due to the tax cut, 10% was the organic growth rate. This year, we see that organic growth rate dropping to about 5%, a little less than market expectations.

Market expectations starting to lower is creating volatility. Realized volatility, for the last few years around 8%, will revert to the mean and trend toward 16%. The Fed underwriting lower rates and a zero interest rate world where assets were pushed higher and higher and higher, forcing volatility down--that is a thing of the past.

Very large deficits by the U.S. government will lead to a record $1.5 trillion of Treasury issuance next year. The Fed will buy zero. If you go back to quantitative easing, there was around $600 billion sold a year ago, and the Fed bought half of it. It’s a big change.

We expect the Fed to tighten one more time, possibly two, in the coming year to 18 months.

The big unknown is inflation. If we start to get a whiff of inflation, because we are at 3.7% unemployment, that can push rates higher.

We think rates will move higher in 2019. It will be another negative year for fixed income. Unlike this year, high yield should do pretty well, contrary to what most people think. Because growth rates are at 2% and earnings are still improving, default rates will remain low. Spreads are blowing out already; now you’re getting paid 7-7.5% yield. You may not earn the full 7, 7.5%, but we think you’ll earn 3 to 5. You may give up a little bit of price, but we think it will still be a positive return. Treasuries maybe not so much.

Emerging markets are the most volatile of all the credit markets, but our top expected return for this year is playing Argentina. Based on how much it backed up last year, it’s offering very, very good value. It’s not until you have some more certainty around Macri and this election [in October] that you want to start to deploying capital aggressively. Right now, for a trade, we’re beginning to buy.

Louis Hanover: EM sovereign bonds are reasonable, around 7% yield — pretty good. Two-thirds investment grade. It’s backed up from 5% this year, 6%. It’s gotten clobbered. So we like it.

What are the risks to your outlook?

Richards: No. 1: Is the Fed moving too aggressively? No. 2, inflation expectations. No. 3, will negotiations with China turn into an all-out trade war, where the impact to the economy could be at least 50 basis points of GDP. No. 4, Europe: is it hard Brexit? Is it Italian recession? Is the transition from Merkel going smoothly? In the latest quarter, German GDP really slowed. Will the yellow jackets in France gain prominence and try for political change? Then there is Mario Draghi and the ECB: one of our top expectations for next year is that European investment grade and high yield become considerably cheaper because the ECB moves from QE to a neutral stance when they begin raising rates. Europe needs a easy policy, but the zero rate environment is creating some other issues, like bubbles in some of the sovereigns.

In 2018 it was fashionable to fret about the lowest rung of investment-grade. What’s your view?

Richards: There was $760 billion of BBB U.S. corporate bonds in year-end ‘07. Today, that’s $3.15 trillion.

Hanover: High yield bonds and leveraged loans have a little bit more than doubled, but not four times. The healthy parts of the market, S & P 500 companies, have record earnings, things are feeling good, companies are buying other companies; in good times when you are normally squirreling away money and delevering, BBB companies are levering up. Look at the leverage implied: A lot of these look like high-yield bonds. Bonds that look like BB or worse—it is a big number. Some people say $1 trillion; we think it’s a little bit higher.

The rating agencies are being lenient. Companies promise synergies, cost cuts, being very rational with their cash, [that] they’re going to delever. But they’re running on a treadmill. Everything has to go perfectly swimmingly well for them to maintain that rating. It just always doesn’t roll that way. There will be some natural hiccups, before the economic cycle contributes to anything.

Richards: The last big story [the ratings companies] believed that didn’t work out was the asset-backed and mortgage CDO story. Over 80% of all investment-grade CDOs they rated prior to ‘08 defaulted. The rating agencies have gotten it wrong in the past, will get it wrong in the future, because there’s a lot of unknown information. But what’s absolutely known are what leverage is today, and what historical rating parameters have been. A big swath are mis-rated. They can currently sustain [it], but once earnings slip and you move to a more difficult environment, there’s a reconciliation.

The amount of BBBs in the next cycle that fall to high yield, the fallen angels, will approach $500 billion. It’s a staggering number. High-yield market liquidity is one-tenth what it used to be. The market won’t be able to handle it. It’s setting up for new pretty stunningly large opportunity.

How are you expressing this view in your portfolios?

Richards: We’re starting to set up a basket of shorts in BBBs, in bonds, and [credit-default swaps]. These are part of Lou’s portfolio construction today. We’re focused on investment grade, the most highly leveraged single-names.

But you think high yield will do OK?

Hanover: We’ve had a year of no return. Last year, we just got the coupon. So we’re not calling for a huge year next year, but there’s enough cushion in coupon. We think the market grinds out about 500 over Treasuries; right now [it’s] 440, 450, depending on the index. If that gaps out quickly, you’ll have some negative return. But if it takes four months, it’s nil. You could get 18 months with no return.

What are your concerns?

Richards: Less than 20% of all loans a dozen years ago were covenant-lite, and 80% had strong covenants. Today’s the reverse. [Covenants] get you to the negotiating table. In the next distressed cycle, for that exact reason, we expect the default rate will only go to 7 instead of 10. Default rates measure trailing 12 months. At some point, a deferment will lead to restructuring, and that might lead to lower recovery rates, because they’ve eaten away a lot of value.

Hanover: It’s little lap waves hitting the beach. You’ve got a little stress in retail, so you see this in Neiman Marcus and PetSmart: I lend you $100 million to buy that building, and six months later you dividend half of it out to yourself. Who would do a mortgage where you could lose half the collateral? That’s the market funding [PetSmart’s] purchase of Chewy; they dividended 35% of it out. That’s set the stage for a fight with creditors. That was right in the document; that wasn’t even trickery. It’s going to keep happening in different industry verticals.

In ‘08, you had the big crash, and pop; this is going to be pain, pain, pain, distress exchanges, rescue financing, and then doing whatever you can do with the [capital] structure: grabbing collateral, making yourself more senior, delaying the day. Maybe some companies recover; a lot don’t. It’s going to roll to one sector after another.

What about private debt?

Richards: It’s just remarkable how large the whole shadow banking system has become. Pre-08, the banks lent to these higher-yielding middle-market companies. Since the beginning of 2017, there’ve been over 100 fund offerings in middle-market direct lending. It’s outrageous. We believe the market has grown to $600 billion. Institutionally traded leveraged loans and high-yield bonds combined is $2.4 trillion.

Small companies are big problems when they need to be fixed. It takes just as much care, but there’s less of an ability to turn around a smaller company. There’s going to be a lot of value destruction for aggressive lenders in the middle market space. There’s too much capital chasing around those segments, with too low rate expectations and too weak covenants.

We much prefer, [in] this part of the cycle, not to be a cash-flow corporate middle-market lender, but to be an asset-based lender. In asset-based, we’re underwriting to our downside of getting our principal back. It’s backed by a collateral package of plant equipment, inventory receivables, real estate, aircraft, health care royalty streams—a whole litany of different types of assets. We’re able to earn a pretty reasonable and safe cash flow.

Will you buy when baskets of small middle-market loans are on fire sale?

Richards: Down 30 points, yes. Whenever the distressed cycle starts to materialize.

2020?

Richards: 2020. This year we harvest a lot of what we have and let cash start to build up. We’re setting up for a very, very big distressed opportunity, whether it’s the latter half of this year, end of this year, or into the following year.

Former Toys “R” Us employees have blamed hedge funds for the company’s abrupt liquidation. They’ve petitioned the funds’ public-pension investors to withdraw their money. Does that worry you?

Richards: We want to work in a consensual way with corporate boards and companies, to come up with a rehabilitation plan that’s positive for the company. We try to avoid liquidations. You’ll have more successful outcomes when you buy good companies that can be restructured, as opposed to playing for liquidation value, or not having proper planning in place and seeing it end up that way.

Hanover: There wasn’t proper planning in place. I hate to bash the sponsors.

Richards: But there’s a reason why they’re coming up with those funds for those employees, because they realize they didn’t properly plan for a restructuring.

Hanover: They could have restructured around 200 stores. They just were too slow. The bankruptcy code lends itself to rehabilitate companies. To liquidate it is really a bit of a failure.

Richards: It’s always our objective to get paid par and to earn interest income as stated in that bond. If we can help the company achieve that and make it through troubled times, we feel very good about the work we’re doing.

Thanks, all.

Celgene Stock Is Soaring After Bristol-Myers Squibb Made an Offer to Buy It. Investors Should Get Out Now.

Photograph by Jayme Gershen/Bloomberg

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Celgene stock (CELG) has struggled over the past year as the company’s top-selling drug faces looming competition, lawsuits, and government scrutiny. So investors should see the offer from Bristol-Myers Squibb (BMY) to buy Celgene as a New Year’s gift. And with Celgene stock trading 25% higher on Thursday morning after news of the deal broke—even as the broader S&P 500 was down more than 2%—shareholders probably shouldn’t wait around to see if the deal closes.

Selling now means that Celgene investors would be leaving a lot of potential upside on the table—as much as half of the deal’s value. Both companies face uncertain prospects as the government and consumers scrutinize drug prices, and even if the deal overcomes several regulatory hurdles, the payoff may not come for years.

Bristol is buying Celgene for $74 billion, or $102.43 per share. That’s a 54% premium to where Celgene stock traded at Wednesday’s close. And Celgene shareholders are eligible to receive additional cash payouts of as much as $9 per share based on FDA approvals of drugs now in the pipeline—a benefit known as a contingent value right, or CVR. But because about half the value of the deal would be in Bristol-Myers Squibb stock, which was down more than 13% on Thursday morning, the actual value to Celgene shareholders could be considerably less.

“The total offer value will be contingent on Bristol’s stock price,” Leerink analyst Geoffrey Porges wrote in a note before the market opened on Thursday. He noted that if Bristol’s stock slides the way pre-market trading indicated it would, the premium for Celgene shareholders would fall from 54% to 41%, not including the CVR.

Celgene is highly dependent on one drug: the myeloma treatment Revlimid. It expects Revlimid to account for 65% of its $15 billion in revenue this year. But Revlimid faces serious challenges, including legal fights with generic drugmakers. The Trump administration has vowed to open up competition to drugs that have enjoyed extensive patent protection. It has highlighted Revlimid as a drug that has drawn complaints from generic drugmakers looking to study it as they develop competitors.

Celgene says that its processes “protect the public health.”

Celgene may be able to protect the patent for longer and ward off government intervention, but the stock is likely to be weighed down because of the uncertainty for a significant amount of time: “It seems the market was not going to get clarity on how the next three years would ‘change’ the problem and hence get the stock up sustainably,” Jefferies analyst Michael Yee wrote in a note.

Beyond the patent issues, Porges sees another potential risk: While Celgene shareholders are likely to approve the deal, Bristol shareholders could balk.

“This transaction dilutes investors’ exposure to Celgene’s patent cliff, relieves Celgene investors of the trials of the company’s management decision-making and offers immediate upside that would otherwise take many months, or even years, to be realized,” he wrote.

After a tough 2018, the deal gives Celgene investors a lucrative escape hatch. They should take it.

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