Howard Marks, a highly regarded figure in the financial world and co-founder of Oaktree Capital, is renowned for achieving impressive returns with distressed debt investments. He regularly shares his insights through memos.
In an October 2023 memo, Marks expressed the view that investors should allocate a significant portion of their portfolio to bonds. During a meeting of a non-profit investment committee, he stated:
Sell off the big stocks, the small stocks, the value stocks, the growth stocks, the U.S. stocks, and the foreign stocks. Sell the private equity along with the public equity, the real estate, the hedge funds, and the venture capital. Sell it all and put the proceeds into high yield bonds at 9%.
That’s a confident statement. His argument isn’t new, given that the record pace of interest rate hikes, bonds are now providing yields that are comparable to equity returns.
Marks argued that while the S&P 500 has historically delivered annual returns exceeding 10%, high yield bonds can currently offer 8.5% or more. With such comparable returns, there are fewer reasons to take on equity risk.
Additionally, he highlighted that interest income from bonds is a contractual obligation, in contrast to stock returns, which are contingent on market sentiment. Thus, returns from bonds are guaranteed, barring default.
Critics may argue that high yield bonds are risky due to their non-investment grade status, making them more susceptible to defaults. However, Marks contended that a skilled manager could effectively diversify this risk. He also asserted that stocks would fare worse in the event of a wave of defaults.
Furthermore, Marks posited that the low-interest rate environment enjoyed by the stock market for over a decade is unlikely to return. He believed that stock investors tend to be overly optimistic. If he is correct, high yield bonds would offer greater certainty in beating inflation and meeting investors’ required returns compared to stocks.
Acknowledging that bonds, not just high yield bonds, presently offer attractive yields, I can understand why some investors may question the need for taking on equity risk. U.S. bonds, for instance, can provide yields close to 5%, exceeding the yields of many dividend stocks that investors typically seek.
The choice between high yield bonds and stocks ultimately hinges on the quality of the investments. High yield bonds often represent weaker companies. I agree that these bonds are a preferable option if one is choosing between lower quality, undervalued stocks and high yield bonds. However, in comparison to high-quality businesses, high yield bonds may not be as appealing, at least to me.
I took a look at the yields of various high yield bond ETFs, and I found that their average yield-to-maturity indeed exceeded 8%. Here are the five largest high yield bond ETFs and their respective yields:
Ultimately, individuals tend to remain entrenched in their investment comfort zones or fall victim to habitual behavior. Those who find solace in stocks are prone to maintaining their allegiance to this asset class, while the same principle applies to bond investors. For the most part, portfolios often remain largely static unless they belong to short-term traders.
Marks observed the same behavior and he lamented:
Here I’ll mention that, over the years, I’ve seen institutional investors pay lip service to developments in markets and make modest changes in their asset allocation in response. When the early index funds outperformed active management in the 1980s, they said, “We’ve got that covered: We’ve moved 2% of our equities to an index fund.” When emerging markets look attractive, the response is often to move another 2%. And from time to time, a client tells me they’ve put 2% in gold. But if the developments I describe really constitute a sea change as I believe – fundamental, significant, and potentially long-lasting – credit instruments should probably represent a substantial portion of portfolios . . . perhaps the majority.
Marks implied that credit instruments should represent a substantial portion of portfolios in light of significant and potentially long-lasting changes in the market, but the familiarity bias may still influence investors’ choices. As for me, I seem inclined to stick with stocks because I have no competence in evaluating high yield bonds.
Forget high yield bonds if one is not familiar with the ETFs – go for SSBs and have a mix of stocks and SSBs.