Howard Marks makes the case for investing in debt
Oaktree Capital Management co-chairman Howard Marks has shared his views on debt in a new memo, laying out the risks and rewards for investors and borrowers alike.
The billionaire debt investor noted that indebted people or companies are more likely to run into trouble than those who are not in debt, as they are vulnerable to the possibility of default, foreclosure, and bankruptcy.
However, he added that this does not mean that debt is a bad thing that should be avoided.
In his view, the more stable the assets, the more leverage it’s safe to use.
“Riskier assets, less leverage,” wrote Marks. “It’s that simple.”
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Marks explained that debt capital is usually cheap relative to the expected returns, which can motivate more equity investments. Therefore, it can be an efficient tool to use in lieu of equity.
However, he said that it is important to recognise the role of volatility.
“Even if losses aren’t permanent, a downward fluctuation can bring risk of ruin if a portfolio is highly leveraged and (a) the lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or (c) the violation of regulatory or contractual standards can trigger forced selling,” he wrote.
He added that the extreme volatility and loss occur infrequently, which can lead to apathy among investors who become used to normal investing conditions. Over time, this can lead regulators to relax their rules and investors to increase their leverage.
“But when events turn negative, this process goes into reverse,” he wrote.
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“Leverage is penalized, not rewarded. Thus, its use declines. And importantly, lenders provide less and try to demand repayment of outstanding leverage if they can, leading to negative consequences for borrowers.”
He suggested that investors should try to use less than the maximum available leverage.
“Clearly, it’s difficult to always use the right amount of leverage, because it’s difficult to be sure you’re allowing sufficiently for risk,” said Marks.
“Leverage should only be used on the basis of demonstrably cautious assumptions. And it should be noted that if you’re doing something novel, unproven, risky, volatile, or potentially life-threatening, you shouldn’t seek to maximize returns. Instead, err on the side of caution.
“The riskier the underlying assets, the less leverage should be used to buy them.”
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