Howard Marks on Investing in a Low Interest Rate Environment

How are return high returns achieved? High risk-adjusted returns, how do you get high returns with low risk? The answer, in my experience, is investors make money most safely and most easily when they do things that other people are unwilling to do.

What has been the dominant characteristic of the financial environment over the last 10 years? The answer is low interest rates. Uh, generally speaking, I mean the all-time lows of interest rates were hit during that period, and interest rates, while having been raised in recent years, are still extremely low.

The effect, the impacts of that is to raise the value, the discounted cash flow of most businesses, to increase the value of businesses, to provide a wind at the back of many businesses, to encourage economic results—all those things. That's why the central banks of the world lowered interest rates 10 plus years ago to fight the global financial crisis, and of course it did work.

But that has left us with an investment environment characterized by low interest rates, and that's the reason for talking about them today. So I've been saying for some time—I still believe that today—the uncertainties are unusual in terms of number, scale, and insolubility. Things like geopolitics, etc.

The perspective returns in many asset classes are historically low because of the low interest rate environment. Asset prices range from full to high depending on which asset category you're talking about, and pro-risk behavior is widespread. They taught me at Chicago 50 odd years about the importance of risk aversion in terms of causing the positive correlation between risk and return, and that when people are risk averse, they'll do thorough due diligence, and the market will be a safe place.

But sometimes they forget to do that. They engage in pro-risk behavior, and the environment becomes more risky. The bottom line, I think, has been and is that we're living in a low return, high-risk world. Some of the environmental indicators over the last couple of years include the 10th year of an economic recovery, the longest bull market in history, the ascendant super stocks, the FANGs, strong demand for corporate credit, money flows into emerging market debt, record fundraising for private equity, the onrush of capital for tech and VC investing, and interest in cryptocurrencies.

And uh, I think that these are the important hallmarks of the last couple of years. And what do they mean? We were talking about that before, right? What does it mean? What it means to me is that the markets over the recent years have been shaped by optimism, trust in the future, faith in investing, and investors, a low level of skepticism and risk tolerance, not risk aversion.

So the first question is, do you agree? You should ask yourselves: does this guy know what he's talking about, or is he exaggerating, or has he left out a bunch of things to color his presentation? These are the things that I think are reflected in these things.

These things have to be present for these things to happen, in my opinion. My point is that attributes like these do not contribute to a positive climate for prospective returns and risk. The increase of optimism, the increase in risk tolerance, the low level of skepticism contribute to asset appreciation.

But, of course, that asset appreciation does not render the world safer. We have to be cognizant of that. Why are prospective returns low? [Music] I again, at Chicago, it all starts here at Chicago for me back in '67. And I learned about the capital market line.

It begins over at the left with the risk-free rate, with zero risk, and it proceeds up and to the right to offer investors a potential risk premium as an incentive for bearing incremental risk. That's how the market works.

Now, I'm going to take a minute out since I think I have plenty of time today to say: you ask most people, “What does this slide mean?” Think about it for a minute. Ask yourself, “What does this slide mean?”

Okay, time's up. What most people would say, in my opinion, is two things: Number one, riskier assets have higher returns; and number two, if you want to make more money, the way to do it is to take more risk. Everybody agree? I don't get an agreement, okay?

And I think that both of those are terrible formulations for the simple reason that if riskier assets could be counted on for higher returns, by definition, they wouldn't be riskier. So that's a fallacy. And if you are guilty of that fallacy or have been consciously or unconsciously guilty of that fallacy, I think you should check your reasoning.

Riskier assets cannot be counted on for higher returns, in my opinion. What this relationship means is different. What it means is that assets that appear riskier have to appear to offer higher returns. They don't have to deliver.

So the important thing is to keep that distinction in mind. But anyway, most of the time the market does look like this: The, you know, longer bonds have higher yields than shorter bonds. Low quality bonds have higher yields than safe bonds.

Stocks have higher expected returns than high-quality bonds, and alternative investments offer higher returns than equities—they merely don't have to deliver. So we get a dialogue, and it goes like this.

And let's go back 20 years to 1999. I wrote a memo about this back in '04. I'm still quoting from it; I've gotten a lot of mileage from it. It's called "Risk and Return." Today, and what I observed in '04 is back in force today, I believe.

So people would say, "Well, I can get four percent with no risk in T-bills. If I'm going to buy the five-year treasury and tie up my money for five years, I need five percent. If I'm going to buy the ten-year, I need six percent. If I can get six percent with no risk in a ten-year treasury, I need a hundred basis points more to buy corporates with credit risks.

So that's seven. If I can get six in ten-year treasuries, I need—I’m not going to go into high-yield unless I can get 11." And that's the fixed income world.

"If I can get those kind of returns on fixed income, I'm not going to buy quality stocks unless I think they'll return nine. Nasdaq, I need 10. And by the way, if I can get those returns from public securities, I'm not going to buy—I'm not going to develop real estate unless I think I can make 14, or go into public private equity unless I think I can make 20, or venture capital unless I think I can make 30."

So all along the line, you get people saying, "In order to take incremental risk, I need the expectation of incremental return." Nothing could make more sense, and that is the way the world was back in 1999.

Then we had this thing called the global financial crisis, and the central banks pulled down the risk-free rate from four in 1999 to about zero in some countries. Of course, short-term rates went negative in order to stimulate economies, recapitalize financial institutions, and when the risk-free rate was pulled down to zero, everything else followed.

And now it goes like, "Well, if the return on cash is zero, I'm not going to tie my money up for five years unless I can get one. Ten years, I gotta have one and a half," and so forth. "I'm not gonna—I wouldn't buy high grades unless they paid three. I wouldn't buy high yield unless it paid six," and so forth.

So you can see that the demanded returns—all investing is relative. The decisions are relative decisions, and so all of the decisions are still sane in relative terms, but taking place at lower levels in terms of prospective return. So this is the reason why prospective returns are low today, and this is, of course, as I say, I think the most important single characteristic of the financial environment over the last decade.

Now, investors in many markets have taken on increased risk in order to access returns above those on safe assets. So the person who used, like me, all the money I had, you know, six, seven—I was concerned about the environment, so I took all the money that I had outside of Oak Tree, and I put it into treasuries.

One, two, three, four, five, six-year treasuries—it's called the ladder portfolio for those of you who are in the bond business—and it is the dumbest form of investing known to man. You have this progression of maturities. The closest in one matures, it goes to the back of the line. You always have a portfolio which has one, two, three, four, five, six-year maturities. You always have some money coming due within a few months, and you know you can't make much, but you can't lose.

And the yield on that portfolio was over six back in '07, and of course today it would be over two. So, you know, most people, you know, I meet with pension funds and endowments and insurance companies, and they can invest four, two, three, four percent. Many of them need seven or eight, so that means you can't do much in the low return safe assets that you used to invest in.

So people have had to push out the capital market line in pursuit of tolerable returns in the low return world. That has caused there to be a lot of money chasing limited opportunities in the risk markets.

The safe close-in markets—the government bond market, high-grade bond market, even the stock market—are by definition much larger than the alternative markets of real estate, private equity, venture capital, and so forth, and even private credit. And you've had a lot of money moving from the safe asset classes to the risk asset classes, and when a lot of money hits a small asset class, we know what happens.

And I believe that as a result of the demand for returns—well, let me say this: You know, February 7, I wrote a memo called "The Race to the Bottom," and I talked—I said in there that the market for buying investments or making loans is like an auction house. And when some—when an opportunity goes up at an auction house, it goes to the person, the highest bidder. The highest bidder is, by definition, the person who is willing to accept the least for his money, and the same is true of the securities markets.

I want to buy some stock; I want to pay 32. Josh says he'll buy it at 32 and a quarter, and Tom says he'll pay 32 and a half. I don't get any; Tom gets the stock. He's the highest bidder. But of course, he gets a worse deal than I would have got at 32, but he makes the investment.

The trouble is that when there's a lot of money in investors' hands and they're hot to trot to put it to work, then the bidding maybe goes too far, and in the credit markets, people bid up the price, which means they bid down the yield and they bid down the safety. That's the way the auction goes.

And I believe that the race to the bottom has been underway in the credit markets, and that is to say investors are competing for the limited opportunities in the risk markets by volunteering for low returns, weak structures, and high risk.

Again, next question: do you agree or do you not agree? As we go along, that's a question that you should all be asking.

So I believe that we have seen over the last few years what I call the seven worst words in the world: "Too much money chasing too few deals." And that was the title of my September memo, "The Seven Worst Words in the World."

When that's going on, is that going on? Do you think it's been going on? When it's going on, that's troublesome, and you should recognize it and act accordingly.

How are return high returns achieved? High risk-adjusted returns, how do you get high returns with low risk? The answer, in my experience, is investors make money most safely and most easily when they do things that other people are unwilling to do.