Investing in non-investment grade bonds, leveraged loans, and preferred stocks is potentially more compelling than investing in common stocks at present.
Topics covered include:
- Why Howard Marks told institutional clients to sell stocks and buy high-yield bonds instead
- The contractual agreements comprising bonds, leveraged loans, and preferred stock give them an advantage relative to common stocks
- How preferred equity exhibits attributes of both bonds and common stocks
- What is the expected return and risks for high-yield bonds, leveraged loans, and preferred stock
- How do we invest in these three asset types
SPDR Bloomberg High Yield Bond ETF (JNK)
iShares iBoxx High Yield Corporate Bond ETF (HYG)
Invesco Senior Loan ETF (BKLN)
iShares Preferred Stock ETF (PFF)
Virtus Seix Senior Loan ETF (SEIX)
DoubleLine Flexible Income Fund (DFLEX)
BlackRock Debt Strategies Fund (DSU)
Barings Corporate Investors Fund (MCI)
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 452. It’s titled “Beyond Stocks: The Allure and Strategy of Credit Investments.”
There are a handful of investors who have greatly influenced my approach to investing. These are investors whose firms my former clients, and in some cases myself, have invested with over the years. These investors include Seth Klarman, Jeremy Grantham, Howard Marks, Bill Ackman, and others.
Last December, one of those investors, Howard Marks, who is co-founder and CO chairman of Oaktree Capital, released one of his periodic memos titled “Sea Change.” Here’s a key sentence from the memo. He put it in bold.
Marks wrote: “As I’ve written many times about the economy and markets, we never know where we’re going, but we ought to know where we are.” He’s referring to taking the market’s temperature. What are investment conditions? What are expected returns, valuations, yields on bonds, and other credit instruments?
We looked at using the market’s temperature, investment conditions, in an episode where we discussed Howard Marks, episode 397, on investing in cycles. Another quote from that memo, “Sea Change”, by Marks. And this really gets to the thesis of the memo.
“We’ve gone from a low-return world of 2009 to 2021, to a full-return world, and it may become more so in the near term.” By full return, we’re talking higher returns on cash; something we’ve discussed in the last few episodes, where we can earn over 5% on cash. Marks continues, “Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets.”
Credit instruments or investments where the return is primarily driven by a contractual agreement between the investor and the investment sponsor. Think about common stocks. There is no contract that a company that has publicly traded common stocks has to pay dividends, a portion of the profits to the shareholders. No contract.
But dividends make up a big component of the return. There is no contractual agreement that these companies have to grow their dividends or earnings, although management has an incentive to do so. And there’s definitely no contract as to what investors should pay for those cash flows.
Marks wrote in a follow-up memo to Sea Change that he released in May 2023. “With equities, the bulk of your return in the short or medium term depends on the behavior of the market. If Mr. Market’s in a good mood, as Ben Graham put it, your return will benefit, and vice versa. With credit instruments, your return comes overwhelmingly from the contract between you and the borrowers. You give a borrower money upfront, they pay you interest every six months, and they give you money back at the end.”
Then he discusses that if the borrower doesn’t pay, the creditors can get ownership of the company through a bankruptcy process. And that gives the borrower an incentive to actually adhere to the contract.
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