The Insight: Conversations – This Time Might Be Different with Howard Marks and David Rosenberg

0:04Hello, and welcome to The Insight by Oaktree Capital. I'm Anna Shemansky, Oak Tree's senior financial writer, and today I'm pleased to be joined by Oak Tree's co-chairman, Howard Marks, and David Rosenberg, co-portfolio manager of Oak Tree's U.S. and global high-yield strategies and the global credit strategy. Today, we'll be discussing topics from Oak Tree's recently published piece, The Roundup, which collects insights from portfolio managers across Oak Tree. Thank you both so much for joining me today. Thanks for having me. Great to be here. I'd like to begin by taking a broad look at financial markets.

0:42Howard, you've recently noted that even though investors should typically be wary of the phrase, this time it's different, it's also true that sometimes things really are different. Why do you think this might be the case in financial markets today? And I feel quite strongly about this. I'm not somebody who usually has strong macro opinions, but this time I do. Anybody who came into the investment or financial world since 1980, 43 years ago, which means most of the people working today, have only seen a climate in which interest rates were either declining or ultra low or both. And that has a specific effect on the economy, on the markets, on asset values, on bond prices, and on investor behavior.

1:35And it's profound. But the thing is that the people who I'm talking about probably think that what they've lived through is normal. When you live through something for 40 years, you tend to say, well, that's normal. But it's not. And the one thing I'm confident of is that interest rates are not going to decline by another 2 ,000 basis points. In 1980, I had a loan personally at 22.25%, and in 2020, I was able to borrow at 2.25%. So rates went down 2 ,000 basis points. Not going to happen again. There's no room for it. And then I don't think that the Fed wants rates to be as low as they normally were in what I consider the most suspect period, which was 2009 through 21.

2:23So for that 13 years, the Fed funds rate was zero most of the time and ultra low for the rest of the time. Not normal. But the very low interest rates created an easy money environment in which it was easy for companies to do well. It was easy for them to finance. It was easy for them to avoid default and bankruptcy. Everything was easy. And that's not the way it normally is in the investment world. That's changing too. So I think that the world ahead will be very different from the 13-year period I'm talking about and from the 40-year period of the interest rate decline. And if the environment changes, then it makes sense to me to think that the strategies that work best will change.

3:07It was Einstein, I think, who said that insanity is doing the same thing and expecting a different result. But I'd like to modify that to say, that maybe insanity is doing the same thing in different environments and expecting the same result because the environment in which you're acting has a big influence. So David, this really leads directly into what you and some of the other portfolio managers of the global credit strategy talked about in the roundup, which is the implications for these changes to credit markets. So I'd like you to speak a little bit about that. Yeah. So think about this way.

3:48There's two main changes in credit right now. Yields are high and quality is good. You don't usually get high yields and good quality. It's usually one or the other. But right now you go into credit and you can get eight, 9 % in high yield, for example, and that's a contractual return. Whereas two years ago, you probably get four or 5%. I was joking two years ago, we were going to have to rename the asset class medium yield because it just wasn't that high. And now you have a real contractual return. And the contractual part is really important. It's funny, David Zervos was on TV the other day talking about the difference between debt and equity and how he really likes debt right now because you get a contractual return, especially below investment grade debt, around 9%, 10%.

4:32And what he put really stuck with me because he said, you know, if nothing happens I have debt, I get 9, 10%. In equities, if nothing happens, I get nothing. So there's something to be said for the fact that you can lock in a return. So when you look at asset classes like equities, you need growth. And the reality is we've seen a lot of growth because money was free. When money's free, people borrow a lot of it. And if you borrow a lot of money, you can use that money to spend on growth initiatives and so forth. And now money's expensive. And so I think it's reasonable to assume people are going to be able to borrow less, which means they're going to have less money to spend on growth initiatives and so forth.

5:05But in debt, you don't need growth. For us, the magic is always to make sure you find companies who can pay you back. That's really the key. And right now, if you can do just that, you get a pretty good return, which I think changes the calculus. But the other reality is the quality. The quality is good, and that's important because I think getting a high yield by taking more risk is really no bargain. The bargain is when you can get the yield but not have to take the risk. And COVID did a few things to the market that I think are really important to improve the quality. First off, for below investment grade credit, you had all of what we call fallen angels.

5:37So all these investment grade companies that fell into our market because of all the disruption of COVID. If you think about quality and high yield, for example, the percentage that is double B rated, so the highest quality of high yield is over 50 % of the market. That's the highest we've seen in 10 years. So very high quality. And the percentage that is triple C rated, so the lowest quality of high yield, is the lowest we've seen in over 10 years because during COVID they defaulted. The other thing that happened during COVID is you had all these central bankers basically trying to keep the world going with a global pandemic.

6:11And so they pushed rates so low that you start having all these companies take advantage of low rates to refinance. So you have a company that maybe wasn't going to refinance for two or three more years, but all of a sudden rates are so low, they say, well, I'm going to pull forward. I'm going to do it now. Well, what that does now is it's cleaned up all these balance sheets so that companies now, if something goes wrong, they have a lot of time to figure out how to solve this problem because there's no imminent issue as far as an upcoming maturity. And that's really important when you think about the quality of this market.

6:40And so we're in a period for credit now where you can get a good return, but you don't have to reach for a risk to get there. And we haven't seen that in quite some time. And I know you've also referred to this as a credit pickers market. Can you explain what specifically you mean by that? It's funny. Whenever I talk to people about credit, what I always say is this is below investment grade credit. So the key to survival here is to avoid defaults. That's it. You don't have to be a hero. The yield's already high. The magic is to earn the yield and not give it back to credit. That's what you need to do.

7:12And when I would say that to people over the past few years, everybody would say, yeah, but I don't need to worry about credit. I've got a Fed put. and it was very frustrating because they were right. All you had to do is not sell for two weeks. The global pandemic, it was a window of two weeks before the market was back off to the races. And so my favorite question to people is say, that's fine, you have a Fed put. What happens when the Fed wants to bail you out and can't? What are you gonna do then? And everyone would say, well, what do you mean? The Fed has unlimited tools, they can do this forever.

7:39And I would remark that forever's a long time, you know, are you sure? And here we are finally, at a period where the Fed has to pick. You cannot fight inflation on one hand and support a market on the other. Those are in direct contradiction. And the Fed has picked inflation. Appropriately so, I think. And so now you have to do credit work. And it's funny because when I say this to people now, they say, you're right. I'm going to focus on credit. And I laugh and say, well, it's too late now. If you want a portfolio that's clean of credit problems today, you had to be doing your credit work two, three years ago.

8:08And two, three years ago, when COVID was roiling the market, I remember distinctly having a conversation with a strategist. I called him up and I said, I'm starting to worry about leverage. Leverage is starting to creep up and wondering what you think about this. And he's, why are you worried about leverage? You should look at interest coverage. Leverage doesn't mean anything. Debt is free. You can have a lot of it. And I laughed. I said, well, I get how that means something on a year by year basis, but eventually you have to pay all this debt back. And I think now what the market's waking up to is that if your company had a lot of leverage because the debt was cheap and now your coupon's effectively doubling when you go to refinance, it may not be so easy to refinance.

8:43So you're going to see companies start to emerge in what we call zombie bonds, companies that may not default today. They may not default for another couple of years, but the market's forward looking. They see it coming and the securities will trade off and you get stuck in them. That's what I mean by credit pickers market now is I think that when you think about who's going to do well going forward, if you do a good job picking credits, you're going to do very well because the yield's already high. So you just have to keep it. But those who have been kind of riding the tide with everybody else and chasing the deals are going to find that some of their credits can't pay.

9:13Especially when they have to refinance. And that's going to be where you see, I believe, a separation of the herd of those who know how to manage credit versus those who don't. And Howard, as we talk about the importance of doing one's credit work, I'd like to dive more deeply into the high-yield bond market. I'm curious, when you look at the high-yield bond market today, how does it compare to what you've seen in previous cycles? Well, of course, it's much bigger. Access became a lot easier. What is it today, David? A trillion and a half? Yes, that's right. So when I started in 78, it was$2 billion.

9:46That's quite a far cry. Now you can have$2 billion issues. Yeah, that's right. It's now kind of mainstream. When I started, it was weird. It was outre. People would say, you're what? Junk bonds? But today it's accepted and most people have them. There's lots of people in the business. The market has become more efficient. It's harder to beat the market and the margin of superiority is less. When you find a market which has been ignored and overlooked, you can have what we call an inefficient market in which you can steal stuff. They say there's no such thing as a free lunch. In inefficient markets, there may be.

10:22So when I started 45 years ago, I was convinced that compared to others, perhaps, we could get more return with less risk if we did a better job. The market has to be pretty full of glitches for that to be the case. You're taking advantage of mistakes. If you can buy bonds with really high yields with really low risk, somebody else is making a mistake by making those available to you. So a little time passes and now we can make more return, we think, with the same risk. Yeah, I like to say from time to time you see bouts of inefficiency, an inefficient market, but periods like COVID where things get very inefficient for a short period.

10:59Yes, right. So then you get to a point where you can get more return. You have to take a little more risk, but not fully commensurate. So you can see that the excess of the return over the risk shrinks over time as markets become more efficient. That's just the way it is. You can't really think you're going to find a great market that nobody else knows about where there are great bargains available and it's going to stay that way forever. There's this process I describe as efficientization. I wrote it up in a memo called Getting Lucky in, I think it was January of 2014, because I found the high yield bond market in 1978.

11:32I was lucky to do so. It was a relatively inefficient market. where you could get these great values. But to go to David's point, what I said in that memo is that generally speaking, inefficiency comes from two things, ignorance and prejudice. And people didn't know about the high yield bond market and they were prejudiced against it. Moody said that a B-rated bond quote fails to possess the characteristics of a desirable investment. That's a prejudice. They didn't say it could be a good investment if you can get it cheap enough, or it could be a good investment if the amount of interest it pays more than compensates for the risk.

12:09They just said, no, it's bad. So that was a prejudice, ignorance and prejudice. Those things are largely gone now. The world's a much smarter place than it was 50 years ago, and everybody knows about high yield bonds now and understands them. Most of the prejudice are gone. So I think that what I would call secular inefficiency is much diminished, but cyclical inefficiency still exists. there are still periods when people are afraid, run from risk excessively, panic, want to get out of the stuff they own, especially if it has a scintilla of risk. So they sell these things too cheap. The urgency of sellers produces occasional bouts of inefficiency on a cyclical basis.

12:50And I think it's going to be interesting going forward, because if you think about it, there's this muscle memory built into the market these days that things get really, really bad, Just hold on. And there's a pivot and everything comes back. And I had this conversation with someone the other day where she made this really great point. She's like, why is it that every narrative ends with, and then the Fed pivots and everything's fine? When you talk to the market, and it's really quite interesting to me, because I think just because in recent history, that has been the case, as you pointed out, Howard, when inflation wasn't a problem, it's easy to pivot quickly and keep everything working.

13:24But when inflation is a problem, You can't count on that. And we saw this for a brief window during COVID where companies panicked for good reason. You know, there was a lot of things to be scared about, but people started to panic and sell. And as I've heard from you many times, if you can be a liquidity provider to a market desperate for liquidity, there's great opportunities. But I always joke that it only was two weeks before the Fed showed up to ruin the party by flooding the market with liquidity. But I feel pretty strongly you can't count on that this go around, at least not that quickly.

13:52And that's going to change behavior. Yes. Well, there is this thing called the Phillips curve, which is accepted as, well, it was accepted for a long time as describing inflation. And the lower unemployment went, the higher inflation was expected to go because that would create price pressures in the economy. But in the period we're talking about, 09, when the Fed cut rates and adopted quantitative easing to battle the effects of the global financial crisis until 21, when they had to give up because inflation was going too high. But in between that period, we had ultra low interest rates, ultra low and declining unemployment, and still no ignition of inflation.

14:36So the Fed felt that it could be very accommodative in its policies, and it was. But as David says, nobody thinks that anymore. Now, the potential of stimulus to produce inflation is accepted by all. Again, It's not something new. It's just something that went into suspended animation for a period of time. Well, and it's funny if you turn that around, how do you properly fight inflation if unemployment is still low? You need it to go up and having it go up means the economy is in bad shape and bad things have happened. And so. Yes. And we see commentators on TV, might I say politicians, who say fighting inflation is fine, but nobody should lose their job.

15:12That's like saying you should take this medicine, but nobody should suffer any side effects. The point is that the fight against inflation comes from a slowing of the economy. And the slowing of the economy inevitably will produce some job losses. And to say that we want the curative effects of a less accommodative monetary policy without any pain, it just doesn't make any sense. Yeah, I used to tell people, because people used to ask me all the time, when's the Fed going to pivot? That was the favorite question of pretty much all of 2022. And I used to joke that the Fed doesn't know when the Fed's going to pivot, so how am I supposed to know?

15:50But what I did tell people is what I can tell you with certainty is the Fed pivots when there's a crisis. Something bad has to happen, and then they jump in to save the world from that bad thing. Everyone had been so excited about the pivot that we were in a market where kind of bad news became good news. Earnings are bad. That's good. The Fed's going to have to pivot. And you're like, no, no, that's bad. There's going to be pain before all of this is over. And I think that's something the market, frankly, still hasn't fully absorbed yet. So in this new environment where the Fed may not be able to just easily rescue everyone, are there any sectors in high yields where you think that risk might be higher or lower?

16:26Yeah. So the way I think about it is, so you have a central bank that's fighting inflation. So what does that mean? And simplistically to me, that means they're attacking the consumer. You want to fight inflation, you need people to stop spending money. If you keep spending money on higher and higher priced goods, you're going to have more inflation. And if you have a central bank, which is a pretty powerful entity fighting the consumer, you want to lean away from consumer dependent sectors. So specialty retail type of sector is something that I worry about. Things that are advertising dependent, because as companies start worrying about recession, you're seeing a lot of advertising pullbacks of broadcast, radio, those type of businesses that are really dependent on that type of spending, we're cautious on.

17:05I always like to say boring is beautiful with bonds, but a good, boring food company with stable demand, a healthcare company with stable demand. Those are the type of things that we tend to be looking towards these days, trying to stay away from highly discretionary consumer-dependent sectors. And are you seeing any differences in terms of geographies? We have. It's funny, last year was quite interesting to me. I've been looking at global high-yield portfolios for about a decade. And what I find is that generically, you get about a 50 to 75 basis points premium to go into Europe because it's a smaller, less liquid market.

17:39You got to get paid for the less liquidity. But if you remember towards the end of last year, there was all this fear about supply of natural gas from Russia going into Europe where natural gas goes into electricity, electricity goes into everything. And so it had gotten existential in people's fears. And so the spreads had gotten north of 200 basis points wide from Europe to U.S. And I've only seen that twice. I saw it with the global financial crisis and I saw it with Grexit. And then I saw it at the end of last year. So I remember having a conversation with my colleagues in London, where I said, to me, you look here, Europe is priced to be an unmitigated disaster.

18:14And if it turns out just to be really bad, it's gonna rally. Something's off here. And so we started to buy. So we started looking for things to buy in Europe, less energy intensive sectors you can lean into so that you don't have to compound the risk. But, you know, good credits that were just the baby getting thrown out with the bathwater. But then the weather turned out to be fairly mild. So I learned that the only thing harder to predict than interest rates is weather. And the winter was fairly mild. So instead of depleting storage, there were days where Europe was actually growing storage and natural gas, which is a very important thing to monitor.

18:44And so the fear subsided. So now you're back to parity. Call it 50 basis points or so, pick up and spread. Nothing special. We've leaned back away from Europe and now looking back towards the U.S. because I think inflation is a little bit stickier in Europe than it is in the U.S. It's going to be a little bit harder to fight. And you have a bigger liquid market in the U.S. We look for those opportunities when things break. But right now, I'd say on the margin, I'd go towards the U.S. When we're thinking about risks overall in high yield, obviously the most important risk is always essentially default risk.

19:15And one thing Oak Tree has been saying for a while is that default risk over the next 12 to 16 months is relatively low because there aren't a lot of significant maturities. But I'm just curious, what about when we start to look beyond that? What if interest rates don't come down significantly? Yeah, it's something we talk about a lot because I think it's a likely case, by the way, that rates probably have to stay a little bit higher than people expect for a little bit longer to get inflation truly under control. There's two things to think about when you think about default risk. If you look at maturities, what you find is the maturity wall everyone talks about doesn't really start to pick up until call it 2027 because so much has been pulled forward to refinance.

19:53So it does pick up a little bit, but it doesn't really get big until 27. But if it's 27, you need to refinance. Really, that means you're going to do it in 25 or 26. Nobody waits to the last day to refinance. That's irresponsible. You're going to lose your company because you're playing games with your coupons. If you're going to refinance in 25 or 26, that means the market's going to start thinking about whether you can refinance in 24 or 25 because the market's looking forward. As we talked about earlier, I think that's where you're going to start to see the rubber meet the road, where there likely won't be a lot of defaults in 23 and maybe a small pickup in 24.

20:27But in 24, you're going to start thinking about the companies in 25, 26, they're going to have to come to market and refinance. The average coupon in high yield right now is about 5.7 percent and the yield is close to nine. So you're going to have a meaningful pickup in your interest burden. And the companies who borrowed intelligently and took the money and used it to benefit the credit will be fine. Those who gorged on the debt because it was free are going to find that it's pretty hard to refinance it now that the coupon is double. And that's where I think you have to be careful. David, you know, the way I say it, and I think this makes it really clear, really easy.

21:01Five years ago, somebody went into a bank. They wanted to expand their operation or buy a piece of property or a company. And the banker heard the pitch and he said, OK, I'll give you$800 million at 5%. Now he listens to the pitch. He says, great, I'll give you$500 million at 8%. So there's a$300 million hole that the borough has to fill. And the other thing is, of course, that in my example, the 8 times 5 or 5 times 8, the total interest bill didn't go up on the loan from that bank. But maybe the interest rate goes up more than the amount of money borrowed goes down and the interest bill goes up.

21:36So the point is, we were in an easy money climate for a long time, and we're not anymore. That's the whole bottom line. Also, you got to think about floating rate debt. With fixed rate debt, it's much easier because it's going to be a step function and you can prepare. But for floating rate debt, SOFR is already above 5%. But the reality is the biggest part of the jump in SOFR really happened in the fourth quarter of last year. Most borrowers have at least a one month lag on when they have to reset SOFR. So you haven't even seen the full impact of that yet on borrowers. the floating rate aspect of the market.

22:10Most people have been so excited about floating rate debt because rates go up, my yield goes up. And as an owner of floating rate debt, that was great. Nobody really talked about what does that mean for the credit when rates go up and your interest burden goes up and your free cash flow goes down. That's quite negative. When you think about default risk, you have the maturity wall, which everyone talks about. And I think that's well publicized and correct to look at. But I think you also have to look at the floating rate versus fixed rate mix of your capital structure and the fact that floating rate, when you get to the end of this year, you're going to annualize this impact of higher rates.

22:43It's going to meaningfully change your free cash flow. Staying on the topic of risks, one of my favorite questions to ask is always, what are some of the underreported risks in credit markets today? What do you think people should be paying more attention to that they aren't? Yeah, we talked about a little bit earlier. For me, the biggest underappreciated risk is the market still, and you can see it in the way it reacts to news is still fairly firmly rooted in the fact that, yes, everything's going to be bad and then we're going to have a quick pivot and everything will be fine. You even hear it with certain companies will say, well, this capital structure is a problem if the company has to refinance and rates haven't come down yet.

23:22Instead of the reality, I think that rates are likely going to stay higher for longer and that means you have to reassess your model. You have to reassess your view of free cash flow and your probability of default has to change. So I think that's something that the market hasn't fully priced in yet, in my view. I think you're starting to see the market appreciate the difference in mix of floating versus fixed. So if you look at the loan market versus the bond market, you've seen a lot of the leverage buyouts, which tends to be where the most leverage is employed because you're using leverage to try and drive an internal rate of return.