Gimme Credit

Episode Summary

Executive Summary: Howard Marks argues that credit still offers attractive, contractual returns despite historically narrow spreads. He explains why spreads have tightened, why that doesn’t automatically make credit unattractive, and why public and private credit should be evaluated together. He concludes credit looks better than equities on a relative basis, while private credit offers extra yield but brings liquidity, transparency, and manager-quality risks.

Main Topics: Why credit is back in focus (Priority: 5/5): Marks says rising rates since 2022 shifted investor attention from equities to credit, especially high-yield bonds and private credit, because yields became meaningfully higher after a long low-rate era. What spreads mean and whether they are too tight (Priority: 5/5): He explains spreads as the extra yield over safe debt that compensates for default risk, and argues that today’s narrow spreads are not automatically a reason to avoid credit if they still cover expected losses. Historical returns and the power of coupons (Priority: 4/5): Marks shows that even after spreads tighten, credit can still deliver strong returns because bondholders collect coupon income and, over time, prices revert toward par if the bonds perform. Why historical spread norms may overstate risk (Priority: 4/5): He argues past average spreads may not be the right benchmark because defaults have often been lower than the long-term average, crisis defaults have been exceptional, and the macro backstop from central banks may have reduced systemic stress. Private credit: benefits and hidden tradeoffs (Priority: 5/5): Marks compares private and public credit, noting private credit’s higher yields and leverage but also its illiquidity, inability to mark to market, higher fees, and reliance on manager discipline. Credit versus equities (Priority: 4/5): He concludes that credit currently offers a better risk-adjusted proposition than equities, with more predictable contractual returns and lower uncertainty than the S&P 500’s valuation-implied prospects.

Key Arguments: Credit should be evaluated as a broad category, not as private credit alone; public credit still matters and often offers a cleaner way to access returns. Spreads are a fear gauge, not a direct forecast of actual defaults; they reflect investor expectations about future credit losses. Today’s ~290 bps high-yield spread is narrow versus history, but narrow does not necessarily mean inadequate if expected default losses are even lower. Bond returns are driven by coupon income, price movement, and reinvestment income; even interim price declines can raise realized return if they increase reinvestment yield. Historical average default experience suggests spreads have generally been sufficient to cover losses, and active managers can do better by avoiding defaults and minimizing loss severity. Private credit’s main appeal is yield, but its main drawbacks are illiquidity, higher fees, opaque marks, and the possibility that some managers relaxed underwriting to gather assets. The absence of a market price in private credit can reduce reported volatility, but that does not make the underlying risk disappear. Marks does not see private credit as a systemic-risk analogue to 2008 because it is less levered and less interconnected than banks were pre-GFC. Credit’s expected returns currently look more attractive than equities, especially given that equity valuations imply subdued long-term returns.

Data Points: ICE BofA U.S. High Yield Bond Index return in 2024: 8.2% - Illustrates strong recent performance in credit. High-yield bond benchmark return in 2023: 13.5% - Shows the prior year’s even stronger returns. High-yield bond yield at start of 2022: about 4% - Low-rate era before the Fed hiking cycle. Private credit yield in low-rate era: about 6% - Described as levered to about 9% for investors. High-yield yield/spread in 2022: about 9.5% total yield - Around 4% base yield plus more than 4% spread. High-yield yield to maturity today: just above 7% - Lower than 2022 due to tighter spreads and rate cuts. Current high-yield spread: around 290 bps - Marks says this is one of the narrowest on record. Normal historical high-yield spread range: 350-550 bps; more recently 400-600 bps - His estimate of traditional adequate spread levels. Annualized high-yield return, 2023-2024: 10.8% - Two-year annualized return after the rally in credit. Barclays high-yield return vs Treasuries, 1986-2024: 7.83% vs 5.14% - Shows long-run high-yield outperformance over 10-year Treasuries. Annual return advantage of high-yield over Treasuries: 269 bps per year - Long-run average excess return over 39 years. Average high-yield default rate, 1986-2024: 3.5% - Historical universe default rate used in the spread adequacy discussion. Average loss given default: about two-thirds of principal - Used to estimate annual credit losses. Estimated annual credit loss: about 230 bps - Derived from 3.5% defaults times roughly 66% loss severity. Median annual default rate, 1986-2024: 2.7% - Shows typical year was below the long-run average. Average default rate excluding crisis years and best years: 3.0% - Demonstrates the influence of extreme crisis periods. All-time low high-yield spread: 241 bps - Reached in June 2007 before the GFC. First-year underperformance after buying at 2007 spread low: 11.3 percentage points vs Treasuries - Illustrates near-term pain from spread widening and crisis. First-year underperformance vs U.S. Aggregate: 8.7 percentage points - Same June 2007 purchase case study. High-yield outperformance after 10-15 years from 2007 low: about 3 percentage points per year - Shows long-term resilience despite bad entry point. Spread compression since base-rate cuts: 100 bps - One contributor to lower current yields. High-yield ratings mix in 1999: BB: 32.7% - Benchmark composition 25 years ago. High-yield ratings mix in 1999: B: 54.6% - Benchmark composition 25 years ago. High-yield ratings mix in 1999: CCC and below: 12.7% - Benchmark composition 25 years ago. High-yield ratings mix in 2024: BB: 52.6% - Indicates stronger average credit quality today. High-yield ratings mix in 2024: B: 33.7% - Indicates shift toward higher-quality issuers. High-yield ratings mix in 2024: CCC and below: 13.7% - Near unchanged from 1999.

Pivotal Quotes: "My answer is always the same, can we talk about credit?" — Howard Marks: Explains his view that investors should not skip public credit when discussing private credit. "You can't eat spread or spend spread or pay pension benefits with spread. For those things, you need returns." — Howard Marks: Summarizes why total return matters more than headline spread levels. "The tide has never gone out on private credit, meaning we haven't had an opportunity to see its flaws." — Howard Marks: Describes the limited stress-testing history of private credit in a long, recession-light expansion.

Implications: Investors should focus on total return, expected loss, and manager quality rather than obsess over narrow spreads. Credit still looks compelling versus equities, but private credit demands caution around liquidity, fees, and underwriting discipline.