Marathon's Richards on Looming Treasury Risks, Fed's Stance, and a Stark Warning for Software Lenders

Bruce Richards of Marathon Asset Management paints a cautious picture of the Treasury market, citing immense supply pressures and shifting buyer dynamics that could push long-term rates higher. While the Federal Reserve is expected to hold firm on rates, Richards highlights a significant, underappreciated risk brewing in the private credit space, particularly for lenders exposed to traditional software companies ill-equipped for the AI-driven future.

Key Insights

1. The Long Bond's Precarious Position: A $10 Trillion Supply Challenge

Attribution: Bruce Richards, Marathon

"The truth of the matter is we're running 7% of GDP in terms of deficits and 7% equals about 2 trillion that we're adding to debt each year... there's 10 trillion of treasuries at the current pace of what we need to roll off and refinance as well as the new debt that we add given the deficits. 10 trillion trillion of treasuries in the next year to sell."

Richards expresses significant concern over the sheer volume of U.S. Treasuries set to hit the market. With deficits running at 7% of GDP (approximately $2 trillion annually) and a staggering $10 trillion in Treasuries needing to be rolled over or newly issued in the coming year, the supply side of the equation is daunting. This massive issuance comes at a time when traditional buyers are showing reluctance. Foreign entities, who hold about 30% of U.S. Treasuries, may be hesitant due to trade tensions and a potentially weaker dollar stemming from tariff policies.

The implications for the long end of the curve, specifically the 30-year Treasury, are particularly acute. Richards notes its duration of 18 years, meaning a 100-basis point increase in rates would cause an 18% price decline. This price risk is leading macro funds and hedge funds to short the long bond, anticipating difficulty in digesting the supply, especially as the Fed is no longer a buyer. While not making a definitive rate call, Richards suggests a return to pre-GFC long bond yields of around 6% is plausible, which would dramatically increase the government's funding costs. This concern is amplified by reports of a "buyer strike" from major U.S. institutional investors like DoubleLine, TCW, and Pimco for long-dated Treasuries.

Actionable Takeaway: Investors should be wary of significant duration risk in long-dated Treasuries. The supply/demand imbalance, coupled with potential foreign and domestic buyer reluctance, points towards a higher probability of increased yields and price depreciation for these instruments. Consider strategies that hedge against rising long-term rates or focus on the front end of the curve where demand remains more robust.

2. Fed on Hold: Navigating Inflationary Crosscurrents from Tariffs

Attribution: Bruce Richards, Marathon

"The Fed knows that later this year when tariffs really start to kick in that we might see a higher inflation... We think more like 2.1% PC number becomes a 2.8 to 3.2 range and that's reasonable a 1% increase from here kind of tops. And with that the Fed will want to see how inflation, you know, factors through and before making a move."

Despite global central banks like the ECB, Bank of England, and Bank of Canada leaning towards easing, Richards anticipates the Federal Reserve will maintain its current policy stance for an "extended period." The primary driver for this divergence is the anticipated inflationary impact of tariffs. While current inflation is "well behaved" at around 2.1% (PCE), Richards projects that as tariffs take full effect later in the year, the PCE could rise to a 2.8% to 3.2% range.

This moderate uptick, an approximate 1% increase, is not seen as a "doomsday" scenario but is significant enough to keep the Fed cautious and observant. They will likely wait to assess how these tariff-induced inflationary pressures filter through the economy before considering any policy adjustments. This contrasts with the market's occasional hope for rate cuts, suggesting a potential disconnect that could lead to volatility if Fed expectations are not met.

Actionable Takeaway: Investors should not bank on imminent Fed rate cuts. The prospect of tariff-driven inflation provides a solid rationale for the Fed to remain on hold, potentially longer than markets anticipate. This environment favors strategies that can perform in a stable, albeit higher, rate environment and those that can hedge against moderate inflationary pressures.

3. The "Crowding Out" Effect: Higher Rates Squeezing the Economy

Attribution: Bruce Richards, Marathon

"Now the real issue I think is the knock on effect when you have higher rates, whether it's the front end or the longer end and, and when you have higher rates is a crowding out... There's you know, this crowding out effect that impacts markets and impacts the consumer."

Richards emphasizes a critical secondary impact of sustained higher interest rates: the "crowding out" effect. This phenomenon occurs when increased borrowing costs for the government or large entities absorb available capital, making it more expensive and difficult for other sectors of the economy to access funding. This isn't just a theoretical concern; it has tangible consequences.

Municipalities will face higher borrowing costs for infrastructure projects, corporations will see increased expenses for capital investment and operations, and homeowners will struggle with mortgage affordability, potentially dampening the housing market. Commercial real estate is also vulnerable, dealing with higher cap rates that compress property values and investment returns. This broad-based pressure can stifle economic growth and negatively impact consumer spending as disposable income is eroded by higher debt servicing costs.

Actionable Takeaway: The "crowding out" effect poses a risk to various sectors reliant on borrowing. Investors should scrutinize companies and municipalities with high debt loads or those sensitive to interest rate fluctuations. Sectors like commercial real estate and consumer discretionary may face headwinds if rates remain elevated.

4. Private Credit's Allure and the Achilles' Heel: The Consumer

Attribution: Bruce Richards, Marathon

"It is a great time to Invest and as a lender, we're making returns that equity markets would wish they were making... But there's one sector that's underperforming and negative on the year and that's, you know, consumer discretionary type, you know, retailers and that sort."

While highlighting the attractive risk-reward profile in private credit – where Marathon is achieving equity-like returns with significantly lower volatility (4-6% for their private credit books versus 16% for public equities) – Richards points to a significant crack: the consumer. The high-yield market, generally performing well and yielding around 7.5% with a 350 basis point spread, shows a clear stress point in consumer-facing sectors.

Specifically, consumer discretionary and retail segments within the high-yield market are underperforming and even posting negative returns for the year. This weakness is attributed to the dual pressures of past inflation eroding purchasing power and current higher interest rates increasing borrowing costs for consumers. Marathon has been actively avoiding these sectors, anticipating this consumer fragility.

Actionable Takeaway: While private credit offers compelling returns, selectivity is crucial. Investors should be cautious about exposure to consumer discretionary sectors, both in public and private markets, as these are showing clear signs of strain under the weight of inflation and higher rates.

5. Software Stocks: A Tale of Two Tiers and a Warning for Lenders

Attribution: Bruce Richards, Marathon

"Mark Andreessen making this comment 15 years ago that I will eat the World and I has done a lot for the economy... We now his new saying is I will eat software... I think the default rate will go from one third of the marketplace that you see in software relative to the market to three times the default rates of the traditional marketplace."

Richards presents a nuanced view of the software sector, heavily influenced by the rise of AI. He acknowledges the immense potential for AI to further boost enterprise value for large, incumbent software companies like Google, Microsoft, Salesforce, Snowflake, and Adobe. These "software-first" companies are well-positioned to capitalize on the AI revolution. However, a starkly different outlook applies to a vast segment of the market: the 5,000 software companies owned by private equity.

Many of these PE-owned software firms, often traditional players, may not successfully navigate the transition to an AI-centric model. Richards invokes Marc Andreessen's new mantra, "AI will eat software," suggesting a period of "creative disruption" akin to Blockbuster's demise. For private credit lenders, this poses a significant risk. Unlike equity holders, lenders have their returns capped at par, meaning they don't participate in the upside if a company thrives with AI, but they bear the full brunt of a default. Richards warns that default rates for these software companies could surge from current levels (around one-third of the broader market default rate) to three times the default rate of the traditional marketplace.

Marathon is taking a cautious stance, effectively hitting "timeout" on lending to many software companies in the private credit market. Richards argues that current spreads (which he believes should be "a couple hundred basis points wider") and debt-to-EBITDA ratios do not adequately compensate for the heightened risk in lending to traditional software companies facing a five-to-seven-year loan term with no clear exit and an uncertain AI transition.

Actionable Takeaway: Investors in private credit should be extremely discerning about exposure to software companies, particularly those owned by private equity that are not demonstrably "AI-first." The risk of obsolescence is high, and current lending terms may not reflect this. Equity investors, conversely, might find opportunities in PE firms skilled at transforming these companies or in the public tech giants leading the AI charge.

Insightful Quotes

• On Treasury Supply Pressure (Richards):

  "And so while there's a big bid for the front end Treasuries, when you get out longer along the curve, the 30 year treasuries, it becomes a little more difficult to digest because it has some pretty big price risk."

• On Software Disruption (Richards):

  "We now his new saying is I will eat software. And so what software companies will make it through... I think the default rate will go from one third of the marketplace that you see in software relative to the market to three times the default rates of the traditional marketplace."

• On Private Credit Selectivity (Richards):

  "So I think those spreads need to be a couple hundred basis points wider. I think the debt EBITDA ratios that they're lending at, which has been very, very high because the air, because the recurring revenue needs to be considerably lower."

Market Implications

Bruce Richards' analysis from Marathon points to several critical market crosscurrents. The sheer volume of Treasury issuance ($10 trillion in the next year) against a backdrop of potentially waning foreign and domestic institutional demand for long-dated paper suggests continued upward pressure on long-term yields. This could make government funding more expensive and create headwinds for duration-sensitive assets. A 6% yield on the long bond is not out of the question.

The Fed's likely extended pause, driven by anticipated tariff-induced inflation (PCE rising to 2.8-3.2%), means investors shouldn't expect monetary policy relief soon. This "higher for longer" scenario will exacerbate the "crowding out" effect, impacting municipal finance, corporate borrowing costs, housing affordability, and commercial real estate.

In the investment landscape, while private credit offers attractive returns, Richards sounds a crucial alarm regarding the software sector. While AI will create massive winners among public tech giants, a significant portion of the 5,000 PE-owned software companies face an existential threat. For private credit lenders, this translates to a call for much wider spreads and lower leverage multiples when dealing with traditional software firms, as default rates are projected to triple. Marathon's strategy of avoiding these specific software loans highlights a potential trap for less discerning credit investors. Conversely, this disruption could create opportunities for private equity sponsors adept at AI transformation or for equity investors focusing on AI leaders. The overarching theme is one of heightened selectivity and risk awareness in both debt and equity markets.