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Stepan Lavrouk
Stepan Lavrouk
Articles (585) 

Howard Marks: Understanding Credit Cycles

Nobody intends to pay off their debt

August 11, 2020

Stock market investors sometimes overlook the importance of credit markets. There's an oft-repeated adage that the bond market is "smart money" - that is, that credit investors know more than equity investors. There may be something to this belief - at the very least, stock market investors should be aware of developments in the bond market, especially when the two begin to diverge.

Howard Marks (Trades, Portfolio) is someone who knows a lot about the credit market. His Oaktree Capital has upwards of $120 billion in assets under management, and credit investing is its main focus. Moreover, it is the biggest distressed debt investor in the world, meaning that it targets businesses that are going through bankruptcy and other financial troubles. In an interview with Investec, Marks explained how the credit cycle is the underlying driver of stock market returns.

Nobody pays their debts

Marks began by drawing an analogy between companies and governments:

"It starts really with the fact that most people don't pay their debts. Governments never pay off their debts. Do you think that the U.K. government will ever have a day in the future where it owes less money than it owes today? I know the U.S. government will not. Most companies don't reduce their debt. And most individuals don't reduce their debt. Nobody pays their debts. They rely on their ability to roll their debts over."

The way this "rolling over" works is that a government issues bonds that mature after some period - say, 10 years. At the end of this period, most governments usually go back to their creditors to raise more money to pay off the original borrowed sum. For most governments, especially Western ones, this is not a problem - there is always someone willing to lend to them. Even Argentina, which has defaulted on its debt nine times, had international lenders lining up to buy its bonds with a duration of 100 years.

But companies don't always have the same luxury. Even though raising more debt is not usually a problem for most healthy companies, there are occasional periods when no one is willing to lend - credit crises. Credit is like air - cut off the supply and companies begin to struggle very quickly.

What is the availability of credit dependent on? In short - the appetite for risk among investors. Marks's Oaktree has had three opportunities to do so since its inception: the high yield bond crisis of 1991, the telecommunications crisis of 2001-02 and the financial crisis of 2008. The same rules apply in the credit markets as they do in the stock markets.

When panic is widespread among investors, those who are willing to take on risk can dictate much better terms, ie., get better prices. When greed overwhelms fear, prices are bid up, and bargains are harder to come by. Risk-taking gradually increases until another credit crisis occurs. This cyclical behavior has repeated many times throughout history - investors would be wise to learn from it.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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