Howard Marks, Oaktree Capital — 2025-03-06
-
Japanese
-
Korean
-
Simplified Chinese
-
Traditional Chinese
Memos from Howard Marks 2025-03-06T08:00:00.0000000Z" pubdate title="Time posted: >3/6/2025 8:00:00 AM (UTC)">Mar 6, 2025
- PDF (English)
- PDF (Translations)
- Listen to Memo
- Archived Memos
Subscribe
The questions I get from clients enable me to understand in real time what's on their minds. At various points in the last ten years, the most frequently asked question was "when will the Fed raise/cut rates?" During crises, it's usually "what inning are we in?" For a year or two, it's been "can we talk about private credit?" And in the last few months, it's "what about spreads?"
Ever since interest rates got up off the floor in 2022, there's been increased interest in credit, and that's why I'm devoting this memo to it. It'll come a little closer than usual to "talking my book," but I think the subject justifies that. Most of my references will be to high yield bonds, where I have the most experience, there's the most data, and the fixed coupon rates make the explanations most straightforward. But the points I'll make are applicable to credit in general.
While I'm setting the stage, I want to get one thing out of the way. When people ask me, "can we talk about private credit?" my answer is always the same: "can we talk about credit?" I see no reason why investors should blithely skip over public credit instruments and go straight to private credit. For that reason, I'm going to address both here.
Last year was a great one for credit, illustrated by the 8.2% return on the ICE BofA US High Yield Bond Index. That followed even better results in 2023, when the benchmark returned 13.5%. What's been behind these returns, and where do they leave the credit sector?
Background
As everyone knows, promised yields on credit instruments were meager in the low-interest-rate period I've discussed so much: 2009-21. At the beginning of 2022, before the Fed embarked on its program of interest rate hikes, high yield bonds yielded in the 4% range, with issuance taking place in the 3s and one bond issued in the 2s! I described Oaktree's challenge at that time as "investing in a low-return world." The ultra-low bond yields were unhelpful for most institutional investors, and many got out of the habit of investing in fixed income. There was, however, good interest in private credit, where yields in the area of 6% were being levered up to 9% or so.
In 2022, investors who feared the Fed's rate increases would bring on a recession caused the average high yield bond price to incorporate risk protection in the form of a yield spread of more than 4%, taking the overall yield to roughly 9½%. I argued at the time that these promised returns were (a) high in the absolute, (b) relatively safe because of their contractual nature, and (c) well in excess of the returns most institutions targeted. For these reasons, I urged that credit should be weighted significantly in portfolios.
These high-single-digit yields alone would have given holders healthy returns. However, investors began to buy because they saw there was good value in credit, and they anticipated rate cuts that would make bonds with high coupons more desirable. Over time, investors also became less worried about a possible recession, and this led to reduced insistence on generous risk protection via credit spreads. Increased demand, lower interest rates, and reduced insistence on risk protection in the form of higher spreads is a perfect formula for price appreciation, and it ensued. This caused the bonds' total returns to exceed the promised yields, and as a result, the high yield bond market delivered an annualized return of 10.8% over the two-year period 2023-24.
The flip side of a rising price, of course, is a declining prospective return. As a result of the developments described above, the yield to maturity on the average high yield bond now stands just above 7%, down from 9½%. Just as rising fear and risk aversion cause investments to offer higher prospective returns, rising optimism and risk tolerance lead to lower ones, incorporating reduced yield spreads. (The reduced yield is also attributable to 100 basis points of cuts in the base interest rate.)
What Is a Yield Spread?
Why would someone lend money to a risky borrower when there are plenty of safe borrowers to lend to? The answer is that risky borrowers pay more for their money, and if you can charge a risky borrower an interest rate that's high enough to produce a return above that available on safe debt, even after allowing for expected credit losses, it could be worth taking the risk. That was precisely the theory that underpinned Michael Milken's popularization of high yield bonds in the late '70s, as well as my career.
The differential between the promised yield on risky debt and the yield on a less risky comparator is called a "yield spread," "credit spread," or just plain "spread." It's also called a "risk premium," which is what it is: the incremental return you're offered to accept incremental default risk. Thus, it's the equivalent of an insurance premium: what policyholders pay to get auto insurers to shoulder the risk that they'll crash their cars.
Yield spreads primarily fluctuate with trends in, and investor psychology regarding, defaults. When more companies are defaulting and investors expect elevated defaults in the future, they'll demand more protection in the form of wider spreads. They'll do so to a lesser degree when they're optimistic about creditworthiness. Thus, the spread is a good barometer of investor psychology, or a "fear gauge." It's worth noting the obvious: the spread doesn't tell you what the actual default rate will be, as some mistakenly say. It tells you what investors think the default rate will be. The thoughtful investor has to evaluate that expression of opinion against what the reality is likely to be and assess whether investors are being too optimistic or too pessimistic.
Are Today's Yield Spreads Adequate?
This is the question of the day. Let's say high yield bonds yield 8% and a Treasury note of the same maturity offers 5%, for a yield spread of 3%, or 300 basis points. Which is the better deal? It all depends on the likelihood of default. If high yield bonds have a 4% chance of defaulting each year and you're likely to lose three-quarters of your money in a default, your expected annual credit loss is 3% (4% x 75%). If those estimates are accurate, you should be indifferent between the two. Or (holding constant the 75% loss in case of default), you should prefer the Treasury note if high yield bonds are more than 4% likely to default or high yield bonds if they're less than 4% likely to default.
When I managed high yield bonds, I considered the normal range for spreads to be 350-550 basis points. More recently, I think this has been revised to 400-600 bps. Today, however, the yield spread is around 290 bps, one of the narrowest spreads on record since high yield bonds began to be issued in 1977-78. Does that mean investors shouldn't hold them here? That's what people mean when they ask me, "can we talk about spreads?"
It's essential to note that the "normal" spreads mentioned above have proved far more than adequate. We know this because the unmanaged high yield bond indices – even with their defaults and credit losses – have significantly outperformed no-risk Treasurys. Data from Barclays shows that from 1986 through 2024, the 39-year period covered by Oaktree's record, the annualized return on high yield bonds was 7.83%, compared to 5.14% on 10-year Treasurys. The fact that the average high