2022 Rate Shock

What’s been behind these returns, and where do they leave the credit sector? Background As everyone knows, promised yields on credit instruments were meager in the low-interest-rate period I’ve discussed so much: 2009-21. At the beginning of 2022, before the Fed embarked on its program of interest rate hikes, high yield bonds yielded in the 4% range, with issuance taking place in the 3s and one bond issued in the 2s! I described Oaktree’s challenge at that time as “investing in a low-return world.” The ultra-low bond yields were unhelpful for most institutional investors, and many got out of the habit of investing in fixed income. There was, however, good interest in private credit, where yields in the area of 6% were being levered up to 9% or so. In 2022, investors who feared the Fed’s rate increases would bring on a recession caused the average high yield bond price to incorporate risk protection in the form of a yield spread of more than 4%, taking the overall yield to roughly 9½%. I argued at the time that these promised returns were (a) high in the absolute, (b) relatively safe because of their contractual nature, and (c) well in excess of the returns most institutions targeted. For these reasons, I urged that credit should be weighted significantly in portfolios. These high-single-digit yields alone would have given holders healthy returns.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Since that didn’t cause inflation to rise from its sub-2% level, the Fed felt comfortable maintaining accommodative policies – low interest rates and quantitative easing – for essentially all of the next 13 years. • As a result, we had the longest economic recovery on record – exceeding ten years – and “easy times” for businesses seeking to earn profits and secure financing. Even money-losing businesses had little trouble going public, obtaining loans, and avoiding default and bankruptcy. • The low interest rates that prevailed in 2009-21 made it a great time for asset owners – lower discount rates make future cash flows more valuable – and for borrowers. This in turn made asset owners complacent and potential buyers eager. And FOMO became most people’s main concern. The period was correspondingly challenging for bargain hunters and lenders. • The massive Covid-19 relief measures – combined with supply-chain snags – resulted in too much money chasing too few goods, the classic condition for rising inflation. • The higher inflation that arose in 2021 persisted into 2022, forcing the Fed to discontinue its accommodative stance. Thus, the Fed raised interest rates dramatically – its fastest tightening cycle in four decades – and ended QE. • For a number of reasons, ultra-low or declining interest rates are unlikely to be the norm in the decade ahead.

You wouldn’t think a portfolio consisting of bank loans and high-quality Treasury and mortgage-backed bonds could be vulnerable to a meltdown that would render a bank insolvent. But the scale of SVB’s bond investments, the length of the maturities, and the extent of the Fed’s interest rate hikes put SVB at risk, and the rapidity of the withdrawals caused the problem to run far ahead of the solutions. When looking at SVB’s demise, the decision-making behind its bond purchases stands out as particularly flawed and probably the primary cause of the bank’s failure. According to public reports, SVB management “made a bet” that interest rates would hold steady or fall. While that expectation is implicit in its actions, I find it hard to believe it was a conscious, considered decision, as opposed to an example of mindlessly chasing yield, perhaps abetted by wishful thinking. The bond purchases took place in 2020 and 2021. In that two-year period, the yield on the 30-year Treasury ranged between 0.99% and 2.45%. How could anyone have thought rates that low were more likely to hold steady or fall than rise? Determining how to move forward is always challenging in economics and investing.

I expect this to have a strong impact on the economies of the high-tax states. What CEO will move his company to New York or California in the future? Won’t future company relocations and formations tend to favor the low-tax and no-tax states?  I know a Republican congressman from New York who voted in favor of the tax bill. How could he? Won’t his constituents turn against him and vote him out? He may figure that since he represents a low-income district, his voters won’t be hurt by the loss of SALT deductibility. And that may be true as far as direct effects go. But the second-order consequences could easily see employers move away, taking their companies and the jobs of the congressman’s constituents with them. High-income people may move to chase lower state income tax rates, but folks with low incomes generally are much less able to do so.  The other day a friend told me the top 1% of New York taxpayers pay 50% of the state income taxes. If and when their emigration accelerates, states like New York may get into a negative spiral: a few big earners leave; the state has to raise tax rates to make up for the lost revenues; that increases the differential and causes more big earners to leave; which requires further tax-rate hikes, and so forth. High-tax cities and states may be greatly affected. New York City residents may feel there are attractions that justify the high rates, but neighboring “bedroom communities” lacking those attractions may be affected even more.