No More ZIRP--Let Credit Shine!

Editor’s note: This article has been updated with corrected data.

ZIRP, or zero interest-rate policy, has been common economic policy in Japan since the mid-1990s and had been gaining traction in the United States since 2008. While there was a brief period of rising interest rates from 2016 to 2019, ZIRP was a mainstay in this country—until it came to an abrupt end early last year. This major shift in interest rate policy means it’s finally time for credit investments to have their day in the sunshine.

As long as index rates stayed persistently low, investors were forced to decide: Either accept lower returns on their investments or take incrementally more risk to achieve the same or higher level of returns. Most investors chose to take on additional risk, and some are now starting to understand that high risks can sometimes result in negative consequences. The most obvious examples of this are the failure of three U.S. banks earlier this year and the increasing transfers of assets to special servicing.

However, while some investors are experiencing hardship, those who maintained discipline in their investing approach are finally being rewarded for their patience. High-yield credit spreads, or the rate of return investors are paid for taking a unit of credit risk, have been moving out since the summer of 2021; they now sit more than 20% above the five-year average. Said differently, investors today are being paid 20% more than they would have averaged over the past five years, at the same unit of risk.

High-Yield Credit Spreads

Source: MARKIT CDX High Yield Spread, via Bloomberg

The same trend is playing out in the preferred equity space, where Origin is an active participant. The rate of return on a preferred equity investment in multifamily assets today ranges from 13% to 15%, while occupying 55% to 80% of the capital stack. As recently as the summer of 2022, the range of returns was 10% to 12.5%, occupying from 65% to 85% of the capital stack. This means investments in preferred equity today are generating 20% to 30% greater returns while being protected by an additional 5% to 10% of common equity.

Preferred Equity in Capital Structure

The expected returns of many higher-risk equity investments have materially compressed from more than 18% in 2021 to 12% or less today due to the increase in the cost of debt. In the link, Origin Investments Co-CEO David Scherer explains why equity returns actually need to increase as the cost of debt goes up in order to account for changes to the weighted average cost of capital, or WACC—counter to what’s actually occurring in the marketplace.

Investors are being paid more to take credit risk today than they have, on average, since 2008, while equity investors are being paid less, at a time when they should be requiring a higher return. As we’ve stated dozens of times throughout the years, there’s never a good time to stop investing entirely, though it’s always prudent to re-evaluate how you are investing. We are at the dawn of a golden age for credit investing—where lower-risk, protected investments are being rewarded with higher returns for the first time in years. While it’s impossible to predict how long this period will last, I’m certain it’s here today, and we’re working hard to take advantage of it.

Projected performance doesn’t represent an actual investment and frequently has sharp differences from actual returns. Projected returns are inclusive of appreciation and reinvestment of distributions and are net of fees. An investment in the Fund has the potential for partial or complete loss of funds invested.
*Represents the annual compounded total return achieved from 1/1/2000 – 12/31/2023. Source: Stocks and Bonds: SPDR S&P 500 ETF Trust (SPY) and iShares Core U.S. Aggregate Bond ETF (AGG). Multifamily Real Estate: NCREIF Property Index (NPI) – Apartments. **Represents standard deviation of historical annual returns achieved from from 1/1/2000 – 12/31/2023. ***Calculated as (historical return – 10-year treasury yield)/standard deviation. All data as of 12/31/23.