The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing)

by Howard Marks

I’ll use a “typical” market of a few years back to illustrate how this works in real life: The interest rate on the thirty-day T-bill might have been 4 percent. So investors say, “If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.” Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital market line, normally slopes upward with the increase in asset life. Now let’s factor in credit risk. “If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.” This introduces the concept of credit spreads. Our hypothetical investor wants 100 basis points to go from a “guvvie” to a “corporate.” If the consensus of investors feels the same, that’s what the spread will be. What if we depart from investment-grade bonds? “I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.” So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the Treasury note, if they’re going to attract buyers. Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not “fixed”). But inve...