Beyond Stocks: The Allure and Strategy of Credit Investments
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Walking the money for the rest of us. This is a personal financial on money, how IT works, how to invest in and how to live without worrying about IT. I'm your host David's stein.

Today is episode four fifty two. It's titled beyond stocks, the lure 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 south Carmen, jeremy grant them, Howard Marks, bill acmd in others. Last december, one of those investors, hold Marks, who is co founder and co chairman of oti capital, released one of his period memo titled sea change.

Here's a key sentence from the memo he put IT in bold mark route, 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 markets temperature, what are investment conditions, what are expected or returns, valuations, yields on bonds and other credit instruments. We looked at using the markets temperature and investment conditions in an episode where we discussed Howard Marks about three ninety seven on investing in cycles.

Another quote from that memo, c. Change by Marks. And this really gets to the thesis of of the memo. We've gone from a low return world of two thousand nine to twenty twenty one to a full return world, and IT may become more so in the near turn by full return.

We're talking higher returns on cash, something we've discussed in the last few episodes where we can earn over five percent on cash Marks continues. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on risky investments to achieve their overall return target. Credit instruments are 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, other 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 road in a follow up memo to see change that he released in may twenty, twenty three with equities, the bulk of your return in the short or medium term to on the behavior other market, if mister markets in a good mood, as ben grand put in, your return will benefit and vice versa. With credit instruments, your return comes overwhelmingly from the contract between you and the barriers.

You give a borrowed money up front, they pay you interest every six months, and they give you money back at the end. Then he discusses that if the borrowers doesn't pay, the creditors can get ownership of the company through a bankrupcy process, and that gives the bar or incentive to actually adhere to the contract. The credit instruments that we're going to discuss today are non investment grade bonds, leverage loans or senior loans, which are floating rate non investment grade bank loans that have been sold into the marketplace indicated and preferred stock.

These are three areas that dive invested in for years and and in some ways, they fit my temperament. My first professional job after graduate school was as a credit analyst. I spent two years analyzing banks, grocery chains, other retail stores and businesses that wanted to listen A T M.

From my employer, ncr, or a point of sale equipment or computer equipment, spend a great deal of time trying to figure out whether these borrowers would adhere to the contract or potentially default. And because of that experience, I just have always been more comfortable investing in areas where there is a contractual agreement to receive cash low. What I like about non investment grade bonds, bank loans and preferred stocks is we're highly confident in the best case scenario that's receiving that interest income and the dividing income.

What we don't know is how much of a haircut will get from that best case scenario if there is a default or in the case of preferred stock, if they stop paying the dividend for a time or whether we'll get the principle back most of the time we do. And we have historical statistics to show what percentage the time do non investment great bonds to fall. And even when they do to fall or balloons default, typically, there's a bankrupcy procedure in and there's a recovery of forty to sixty percent of the original principal amount.

Last week in epo de four fifty one, we discussed a formula called the Martin share, which can assist us in determining what percentage of our network should we invest in rescue assets. And that person age depends if the particular investment little stocks is a higher expectant return, but a lower expected risk is measured by volatility or if our risk aversion factor is lower, meaning we're really to take on more risk, then we would have a higher allocation to the risky assets. We also pointed out that when risk free rates are higher, where we can earn more on a risk free basis like today, over five percent than our allocation to rescue assets should be lower.

In mark's memos, he didn't mention the murder share in terms of figuring out how much to allocate to risky assets, but the underlying principle is there. And he went to an investment committee. He still meets with clients, university diamonds and foundations, and he went to a committee.

This would have been last late last year and said to sell off all your stocks, your big cap stocks, your small cap stocks, U. S. And foreign stocks, get rid of your private equity, restate hedge funds, venture capital, sell at all, he says, and put IT in high ye ld bonds that are yielding nine percent.

Now in the memo, he admitted that he didn't think anybody would do that, but his point was hired bonds, which are yielding nine percent. Currently, they yield to maturity that's close to the historical return for stocks, but the volatility of higher bids is less than stocks. The standard deviation arrange returns for high your bones around twelve percent versus nineteen percent for stocks, that the maximum drawl down of non investment grade bonds worst case was around a thirty six percent loss versus sixty percent for stocks.

So here we have an asset class. We're now the expected or return is very attractive. The contract will return before taking into account default, and yet it's less volatile.

And he was speaking to an endowment that is trying to earn enough to meet their spending rate of five percent or which means they need to earn five percent plus inflation. And so if they could earn nine percent, they would be very happy if we look then at current yields. And this comes from our monthly investment conditions and strategy report that we do add money for the rest of us, plus U S.

corporate. Your bonds y'll towards this is nine percent. U. S. Bank loans, leverage loans, they're yielding nine point six percent. And those attractive yields have been increasing as the federal reserve has been raising its policy rate, but they've done very well.

I look at my portfolio over the last eighteen months, the best performers have been A A leverage loan closed and fund that I own d su, it's return ten percent analyzed and another close and funds M, C, I bearings, corporate investors that invest in private debt but non investment great debt. It's return fifteen percent analyst that's compared to negative six percent for the overall bond market. IT has represented by the vicar total bond market E T.

M. So here's two credit strategies, bond like strategies that have tranced the overall bd market. Now partly, it's because these are closed in funds that was selling at a discount and that discount has narrows a little bit, but they also have very tractive yells of over nine percent preference stock is the other credit investment.

IT has elements of bonds, but also of stocks as a hybrid type investment. It's like a bond in in that there is an a contractual agreement to pay a specified don rate. Just like most bond of a specified interest rate, preferred stock says i'll pay a certain dividend amount and that divided is generally as a percent of its offering Price, which is typically twenty five dollars, that dividend yields around five percent to seven percent.

And so IT pays a specific dividend. And then like bonds, if interest rates go up and the prize a preferred stock goes down, then the dividend yield ld based on the market Price goes higher. And so last week, I added more money to one of the preferred stock issues I own and its yielding eight point six percent because its Price have fAllen.

Preferred stock is is like bonds in that many issues get a credit rating from a credit rating agency that looks at the soundness of the issue, the ability the company to meet the dividend. And so if we look at a tf, like the eyes shares preferred stock etf, about eighty percent of its holdings have a credit rating, fifty percent raided, triple b or Better, with most of this being triple b, which means its investment grade, but there's twenty seven percent rated double b. So in some ways there, the sort of a mixed between investment grade and non investment grade bonds for stocks are like bonds in that many can be called early.

They can be redeemed early at the offering Price, which is typically what's known as the liquidation value. With interest rates going up, many of those preferred stocks have fAllen below that liquidation value. And so the odd of being called early because they would need to pay the twenty five dollars per share, that's less.

And so we can see that many preferred stocks are currently selling for a discount to the liquidation value, which means their yields are higher than the coupon rate in in many cases, seven, eight percent or higher. Preferred stocks, though, are likes equity or like common stocks in that its equity capital on ability gy. It's not debt.

And so some corporations are like to issue preferred stock areas such as banks, utilities, where there are some ratios they have to meet or some limits as to the amount of leverage they can have. So by issuing preferred stock, they can still raise capital, but it's not counted against them as as having leverage, which can help their credit rating and and as resolve these more regulated industries like banks and utilities tend to be the biggest issues are preferred stocks. The ice is preferred stocky tf has seventy four percent in financial institutions, in another ten percent in utilities.

The rest are industrial type companies are a regular businesses. So if I look at my preferred stock issues that I own, I own individual ones. I don't have any exposure to to banks or utilities.

My preferred stocks were issued by closed end funds, gobel asa management, a close and find users leverage and and as a result, they borrow money, but they are can also, which you preferred stock, and then I also have some preferred stock issues from mortgage rats, which is a type of company that invest in mortgage back securities. On a leverage basis. So they'll borrow money loans, but they are also issue preferred stock.

So preferred stocks, not debt part of the equity stack, it's junior to that. So if the company defaults the dead holders in the case of a workout where there is some recovery, they'll recover before the preferred stocks holders get any type of payment for stocks, are stock light in that the division could be suspended if a barrow of a dead at someone that issued higher bonds, if they stop paying interest, that's a default. But I prefer stock issue can stop payment of the dividend for a time and then start again without incurring a default.

Now there's a type preferred stock called cumulo preferred stock, and and those are what I prefer. About forty six percent of the preferred stock universe are accumulative. So if the company is suspends the divine, they have to make up that dividend catch up before they can start paying dividends to the common stockholders.

And so that's an additional assurance that we get is preferred stock holder. So I prefer cumulo preferred stock. Turned out many of the non cumulative preferred stock issues of by banks. And again, this gets more to kind of regulations.

The other thing that preferred stock is there's many different types is some the divided can change and so IT might be fixed for a time and then IT could change to variable. And then there's this tax advantage to preferred stocks. As hold us a preferred stocks, we can get qualified an income, which means our U.

S. Tax rate could actually be lower about twenty percent versus if you N A higher marginal income tax bracket or potentially paying over thirty percent on interest income with prefer stock. Because IT is a division and equity dividend, the tax rates are lower, but IT is a stock.

It's not common stock, but IT IT can sell off if the common stock is selling off. Typically there there is some correlation between that. We can see preferred stocks have sold off as interest rates have risen just like with bond, and that has increased the the current yield.

But they can also sell off in market stress when the pandemic hit or the the realization of how severe the pandemic was in march twenty twenty. That preferred stocky T F P F F IT sort of twenty nine percent. I had individual issues that sort of forty five percent.

So we can see some drawdowns in twenty twenty two with interesting ted rising long term bonds as represented by the T L T I shares. Twenty year bond, T, F declined thirty one percent. Preferred stocks declined eighteen percent as represented by P, F, F and the spider bloomberg.

Ao, bi, tf declined twelve percent in twenty twenty two. So preferred stock is a hybrid. So while there is a contract to pay that divided, that dividend can be suspended.

And over time, about six percent of ford stocks see their dividends suspended across the universe on the average in any given year. But again, if it's accumulative position, then I can be made up. And so the actual default rate in terms of bankrupcy is much lower than that.

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So when we think about credit instruments, non investment, great bonds, leveraged loans and preferred stock, we get that pipeline best case yield. And then there is the potential for default or dividend suspension, which can reduce that top line yelled. I've mentioned the six percent I preferred stocks have seen some type of suspension of their division over time.

If we look at non investment grade bonds, Howard Marks and his memo pointed out that the average hio default rate, the ano defauts rate between one thousand nine, seventy eight and thousand and nine was three point six percent, but since then it's been two point one percent. So from two thousand and nine through twenty twenty two, so much lower than that. What we assume on money for the rest is pass because we provide expected returns.

We assume annual default rates, uh, a four percent. And given there's about a forty percent recovery that can reduce that any return for non investment grade bonds by about two point four percentage points per year. So out with a nine percent yield to maturity and we back out two point four percent, that is six point six percent expect to return for non investment grade bonds.

We can do a similar analysis for leverage loans or bank loans. They're yielding nine point six percent right now. We assume a five percent default rate for bank loans, which is is fairly reasonable historically.

If we look at bank loans that the fault rates been less than two percent per year since two thousand nine. And but I was twelve percent two thousand nine in four and half percent in twenty and twenty. And then the other years, because IT is kind of spiky and that's when the economy goes bad.

That's when you see default increase. We're being fairly conservative, is seeing five percent default, sixty percent recovery. And so that reduces the annual return by one point six percent. And if we started with the oil and nine point six percent, that's an eight percent expected return for bankers, that's attractive.

I mentioned the drawdown for hio bonds, worst case maxon drawdowns, about thirty six percent lower risk than stocks with a standard deviation of around eleven or twelve bank loans because their yields are tied to short term interest rates. So it's an additional yield above the risk free rate. They're not as sensitive to changing rates.

And as a result, their standard deviation is much less the volatility, about six and half percent, so half that of non investment grade bonds. And the maximum drawdown historically only been twenty four percent. So it's a fairly lower risk strategy in terms of volatility, but potentially higher default.

But IT also has a higher yield right now. In looking at my portfolio, I have around seven percent of my network in higher bonds and bank loans, and that includes clatter ized loan obligations. And we discussed bank loans and clatter ized loan obligations in great detail in episode four twenty three of the podcast and encourage you to check that out.

So I I have exposure there and I have around six percent in preferred stocks. It's an area the market i'm looking to increase, but there's sort of a caveat. We talk about the attractiveness of credit instruments.

There are two things we don't know. Will there be a recession? During recessions, we typically see the spread or incremental yield of non investment grade bonds and bank loans wide, not because there's more worry about default risk.

And if we look at the spreads now for non investment grade bonds, so they're just slightly below average. So even though we're getting a nine percent yield, the actual spread above ten year treasuries is four point four percent versus the average wing back to thousand nine hundred and eighty three of four point nine percent. And so we're not kidding above average reads right now.

And the best time to invest in hail bond is when spreads are very wide and the economy is improving. Currently, economy is not improving. Economic trends are read in our month investment condition report based on leading economic indicators.

We haven't had a recession yet, but there is reason for some caution recognizing the over the the long term, if this is a more Normal environment, a nine percent yield is attractive for a bonds and nine point six percent for bangalore. We just don't know how much that will be reduced by the default if we enter into a recession. And so my approach has been to make incremental changes.

As i've kept some exposure, he pulled back risk and on credit instruments back in the summer twenty one and then slowly added some back. How do we invest in these areas of the market of credit instruments? What are the ways to do that? But the first way is, is passively using a passive index fund or etf in the ideas is that by having hundreds of not over a thousand positions will earn the yield ld to maturity and IT will be reduced by the average default rate.

So we want get this proportionally hit by the default of one particular issue. So something like the investigation senior one etf, B, K, L, an is a etf that's passively manage effectively a diversified mix of englands, the ashes I box, higher corporate bond T, F, H, Y, G is a way to passively get exposure to higher bonds, the eyes shares, preferred stocks. Etf P F F is a way to get diversified exposure to preferring stocks.

So that's the first way. Pass A, P, T, F. The second way would be an actively managed approach. There are active mutual fund in etf in all of those areas.

There were relying on a management team to make portfolio decisions as to which bank on to purchase, which high bond purchase of which first stock to purchase. And the idea is that the defauts rates will be lower than the overall market because you're doing additional. Credit research.

Now they could be higher if they happen to get one of their positions or several, them default. But we're relying on professionals to make the security selection. Now IT can be A A mutual funder, can be etf.

So a firm that i've invested with for several decades now, I don't currently have exposure is virtually sites and they have a virtual x senior loan etf tickers. S I X and IT has A S C eld at nine point six percent and and hopefully the default rates will be below average and will earn most of that. So that's an example in our mod portfolio examples.

And in my portfolio, we own the double line flex or income fun D F L X IT has exposure to bank loans and also hide your bonds and is actively managing a portfolio. Some other segments of the market, but IT has an S C CEO of seven point eight percent. So this is a very diversified, actively managed approach to get exposure to credit instruments.

And and that's how we've gone about IT in our model portfolio examples. So the second approach is actively managed. The third approach is to purchase individual security. I've done this in my portfolio, but not for bank loans or for higher bonds that i'm not comfortable doing now because they have A A credit research background. I'm comfortable going through the baLances sheet income statement, the cashless statement more so for preferred stocks because I just want to make sure there's enough cash flow to meet the prefer stock dividend.

And so unlike trying to do that analysis of fundament analysis in in analyzing the comment stock there, we're trying to figure out is the market wrong, is the consensus expectation for the forward prospects of that company and terms of earnings and dividends wrong to where the the common stock is too cheap that much difficult to do than analyzing those same financial statements? Is there sufficient cash low and enough of a buffer to meet the prefer stock tivat? And that's something and more comfortable doing.

And that's why I own individual preferred stocks in the mortgage de area, the closed and fans and then have one farm read. But I I wouldn't feel comfortable doing that for senior loans and higher bonds and and really even for most preferred stock issue. So i've chosen in my preferred stock individual holdings very carefully because there are in areas where I I just don't see you to fall IT could happen. The final way than to invest in these areas is closed and funds close and funds differ from an open and mutual one in that they can trade throughout the day on the stock exchange like an etf, but there's A A set amount of shares. So with an open metro fund, the fun sponge is creating every deeming new shares every day.

So the market Price of the mutual und open, the mutual und always ele, the net acid value, which is the value of the assets divided by the shares outstanding, a closed and fund can see its market Price differ from the that s vy because IT trades throughout the the day and the sponsor isn't creating new shares, and so closing funds are are attractive because you can buy them at a discount, but they're also more violent than open ambur funds, because most closed and funds use leverage in order to magnify the return, and the fees are higher. I'll linked to in the show notes a guide we have unclosed and funds. We also have a course that i'll linked to then you there's a lot of complications with closed and funds, but they're pretty fascinating vehicles.

But there is the four ways to invest in these credit instruments, etf and index funds to get the universe ation actively managed muto fantoni etf individual holdings, at least for preferred stocks and closed end funds, there's always trade off. So I agree with Howard Marks that now credit is attractive in terms of the absolute yield, especially for in a more Normal environment where these yids will stay at this time, we don't know what the haircut will be due to default, and we can manage that by using an actively managed fund or et. We also don't know what extent interests could go higher, especially spreads for higher bonds or bank loans if we get into a recession scenario.

And so the approach that i'm most comfortable with, not knowing what the future will be, is to make incremental changes and dollar cost average to increase our exposure. But IT is an unusual period where we can earn returns, equal stocks, common stocks, but by taking less risk. And that is attractive to me and something i'm continuing to look at in my portfolio, in the models, money, money for the rest.

Plus, as we look at the markets temperature, where do we stand today to help us make decisions for the future? That episode for fifty two. Thanks for listening.

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