Oaktree’s Rosenberg says credit will trump equity returns

The sharp rise in base interest rates since early 2022 has meant returns on fixed income have been bolstered.

Investors can earn 4 per cent to 5 per cent from investing in cash or bonds but investing in riskier credit pays more. Investment grade bonds, for example, yield 6 per cent to 7 per cent while sub-investment grade loans and bonds pay about 9.5 per cent to 10 per cent.

While these yields are high, some investors cautiously point out that the premium for owning high-yield bonds is modest relative to historic averages.

Rosenberg says the normal premium for high-yield bonds is between 3 per cent and 5 per cent over the risk-free rate. At 3 per cent, buyers go on strike but at 5 per cent its borrowers that sit out. Currently, the margin is about 4.5 per cent.

Rosenberg – as the professional pessimist – says he expects there will be a recession. Typically, that means a spike in defaults and a torrid period for corporate debt investors. But this time is actually different.

“If you go back in history that’s generally true. I don’t think you can get there this time ”

The reason, he says, is that the high-yield bond market is actually in relatively good health, mainly as a side effect of the pandemic.

The COVID-19 pandemic led to investment grade borrowers falling into the sub-investment grade universe while weaker CCC bonds defaulted. The result is the ratio of higher-rated BB bonds is higher than typical while the share of risky CCC bonds is lower.

Three default trigers

Rosenberg also adds that the three typical triggers for a corporate default don’t seem to be there. One default trigger is a breach of a loan covenant – but since most debt is free of these terms, borrowers have more flexibility.

The second common default trigger is when a company runs out of money, but Rosenberg says companies hoarded liquidity in the pandemic and have remained cautious.

The third trigger for a default is that a company is unable to refinance. But this is also unlikely as most companies took advantage of low-interest rates to lock in low rates and extend the maturities of their bonds.

So corporate debt investors are looking to the so-called maturity walls, and they’re not too worried, at least for now, that companies can find a plan to repay them.

The era of cheap money meant more companies took on more debt. They can’t change the past. But they’re on the hook to service that debt so more cash that would have either gone to pay shareholders or to expand and grow has to be diverted to pay their lenders.

The high yields on offer coupled with the relative strength of the borrowers that are on the hook to pay those yields is why Rosenberg is optimistic that corporate debt may beat equities in a relative and absolute sense.

That doesn’t mean he has a dim view on the prospect for equities. But the key is that debt returns are contractual obligations.

“If nothing happens, I get 10 per cent. In equities, if nothing happens, you get nothing,” he notes.

“It shows you the difference in value right now. If you’re not certain about the path of the economy, it’s a much better way to get the equity like return.”