Howard Marks, Chairman of Oaktree Capital Group, LLC, thinks that by reducing bond buying, the U.S. Federal Reserve (i.e. tapering) will happen to allow the markets to freely allocate capital, according to a transcript from The 2013 Goldman Sachs Financial ConferenceHoward Marks does not believe there is a free money market currently and highlights that rates in part have already taken into account tapering’s impact. So when the actual tapering event comes along, it may not mean much to yields. When Federal Reserve Chairman Ben Bernanke mentioned tapering in May of this year, the 10 year Treasury was yielding 1.5%, now it is about 2.8%.

Howard Marks Oaktree Capital - Risk

Howard Marks highlights that both demand for goods and services and demand for capital are not as strong as prior economic recoveries. Furthermore, inflation is moderate. In Howard Marks’ opinion, the 10 year Treasury rate without tapering will be between 3% and 4%. Therefore, if tapering starts rates may not experience a sharp jump from current levels.

Also see: Howard Marks Talks About Investment Strategy, Fed Policy [VIDEO]

Howard Marks: demand for alternatives increased

Howard Marks noted that his target investor base, being U.S. pension funds or endowments, is targeting a 7.5%-8% return. Considering that Treasuries pay between 1-3%, high grade bonds pay 4%, and stocks return about 6-7%; investors are seeking alternatives to make their targeted returns. So they are looking to hedge funds, private equity, and private real estate to make up the gap. Howard Marks pointed out that hedge funds have not generated 7-8% in quite a while and that private equity and private real estate can generate about 12-14% with substantial variability.

Credit-based alternatives, according to Howard Marks, can help investors meet their target returns as they can generate around 10% net of fees with low variability and a substantial current component. Oaktree has created a suite of five credit-based products and raised about $5 billion over the last year and a quarter. Howard Marks points out that distressed debt deals are not as attractively priced as they were during the crisis as they are no forced sellers. Opportunities are concentrated in a few segments including shipping, power, and non-prime real estate in Europe.

Prosperity creates opportunities in high yield and real estate

According to Sheldon Stone, partner of Oaktree and head of its high yield department, high yield bonds do not necessarily go down in price when rates go up. The negative impact on price driven by higher market rates is offset by the positive impact economic recovery has on the high yield market. Better economic conditions will probably improve creditworthiness of high yield issuers increasing their value. Furthermore, high yield bonds have limited durations which reduces their sensitivity to higher market rates.

Howard Marks notes that real estate is cyclical and that deals are available in private real estate properties and debt. Oaktree just finished raising capital for a fund that invests in both real estate assets and debt, and the firm expects a 15-20% return. Oaktree also wants to take advantage of real estate debt opportunities in non-prime cities using less leverage and targeting a return between 10-12%.