[Music] this is the memo by Howard marks give me [Music] credit the questions I get from clients enable me to understand in real time what's on their minds at various points in the last 10 years the most frequently Asked question was when will the FED raise or cut rates during crisis 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 20122 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 blly 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 BFA 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 [Music] background as everyone knows promised yields on credit instruments were meager in the low interest rate period I've discussed so much 2009 to 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 3es and one Bond issued in the twos described Oak tre's challenge at that time as investing in a low return world the ultr 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% too 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 9 and a half% 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 digigit 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 Ed insistence on risk protection in the form of higher spreads is a perfect formula for Price appreciation and it ensued this caused the Bond's 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 2-year period 2023 to 24 the flip side of a rising price of course is a declining prospective return as a result of the developments just described the yield to maturity on the average high yield Bond now stands just above 7% down from 99. 5% just as rising fear and risk aversion cause Investments to offer higher perspective 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 Milan'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 it's the equivalent of an insurance premium what policy holders 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 credit Worthy 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 3/4 of your money in a default your expected annual credit loss is 3% 4% time 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 consider the normal range for spreads to be 350 to 550 basis points more recently I think this has been revised to 400 to 600 bips today however the yield spread is around 290 bips one of the narrowest spreads on record since high yield bonds began to be issued in 1977 to 78 does that mean investors shouldn't hold here that's what people mean when they ask me can we talk about spreads it's essential to note that the normal spreads I just mentioned 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 treasuries data from barle shows that from 1986 through 2024 the 39-year period covered by Oak tre's record the annualized return on high yield bonds was 7. 83% compared to 5.
14% on 10year treasuries the fact that the average high yield Bond gave investors 269 bips more return per year than treasuries tells us the historical spread was considerably more than sufficient to offset credit losses thus the historical spread shouldn't necessarily be the standard for ad quacy and investors might intelligently opt for high yield bonds over treasuries even at spreads below the historical average thus the key question isn't whether today's spread is historically narrow or not it's whether today's spread is sufficient to offset the credit losses that will occur this takes us back to the calculation I just discussed over the course of Oak tre's 39-year track record in high yield bonds from 1986 through 2024 the high yield Bond universe's default rate has averaged 3. 5% and defaulting bonds have cost investors about 2third of the money they had at stake meaning annual credit losses have amounted to about 230 bips 2/3 of 3. 5% this suggests today's historically narrow spread of about 290 bips would have been enough to offset the defaults that occurred in the past P before that's accepted as the appropriate conclusion on the subject however there are caveats to be considered the average default rate of 3.
5% overstates the typical experience that 3. 5% average is far from the norm out of the 39 years covered by Oak tre's track record there were only 14 years when the universe's default rate was at or above 3. 5% and 25 when it was below the average was pulled up by double digigit default rates during crises in 1990 to 91 and 2001 to 02 if you took out those four years along with the four best years in which defaults were 1.
0% or less the average for the remaining 31 years was just 3. 0% further the median default rate for the 39 years the midpoint of the annual observations was even lower at 2. 7% the historical default rate might not be relevant to the Future in the global financial crisis of 2008 to 09 and the covid-19 pandemic of 2020 central banks and National treasuries showed that they had developed tools with which to counter recessions and credit crunches as a result the default experiences associated with those events were well below those in the earlier crises even though the GFC and pandemic were much more serious in a macro sense thus it can be argued that the macro environment has become safer meaning the historical spreads are no longer called for the average high yield bonds credit rating supposedly an indicator of quality has risen substantially mainly because companies are less concerned about ratings these days large numbers of investment grade Triple B rated companies have opted to increase their use of Leverage and allow their rating to slip to doubleb the upper tier of the high yield Bond Universe the following data shows the change in the ratings profile of the high yield Bond Universe over the last 25 years on December 31st 1999 doubleb rated companies were 32.
7% single B rated companies were 54. 6% and Triple C and Below rated companies were 12. 7% on December 31st 2024 doubleb companies were 52.
6% single B companies were 33. 7% and Triple C and Below rated companies 13. 7% research from Barkley indicates that since the average high yield bond is now higher in creditworthiness today's average yield spread provides a good bit more compensation per unit of of credit risk today than it did at the all-time tight of 2007 active credit managers strive to reduce a the incidence of default in their portfolios and B the percentage of capital lost when defaults occur since the historical spreads have been adequate to protect against average credit losses in the past that means theyve proved more than adequate for investors with Superior Credit discernment for high yield Bond manager with the ability to reduce credit losses through active management there's a greater likelihood that spreads will prove sufficient to offset future credit losses for all these reasons plus one more I believe the concern about historically narrow spreads is very much overblown my additional point is that spread widening is a short-term phenomenon analogous to volatility in stocks if the yield spread widens increasing the demanded yield that results in a price decline for Bond holders but the price decline is temporary whereas the higher interest payments are received every year and then the bond eventually returns to par at maturity assuming it performs I did some research with Oak tre's Nicole Adrien to test this thesis we identified the all-time lowest yield spread on our usual high yield Bond Benchmark and looked to see how we would have fared if we we bought bonds that day the lowest spread was 241 bips reached in June 2007 just prior to the onset of the global financial crisis here are the results for high yield bonds and some comparative indices if you chose that time to invest to view the graphs referenced throughout this memo please consult the written version available on Oaktree capital.
com insights the one-year return on high yield bonds shows unsurprisingly that if you buy a risky asset at the height of its popularity and immediately encounter one of the worst Financial crises the world has seen your initial experience won't be good thus in the first year following the purchase at the low on spreads high yield bonds underperformed treasuries by 11. 3 percentage points and the US aggregate Bond index by 8.
