My first real post at the blog was Yield = Poison. In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued. Short and safe seemed best.
It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.” I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom. Moved the whole portfolio up three notches in four months. Give away yield; preserve capital for another day.
I feel much the same, but not as intensely in the present environment. Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets. But most fixed income assets do not reflect likely default costs. Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while while supply will be high, and try to buy near the end of the quarterly refunding.
There is another sense in which I say “yield = poison,” though. When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield. Wall Street is more than happy to deliver on your desire for yield. It is their top illusion, in my opinion.
Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us. They were offering a full dollar over the usual market price. They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?” [DM: placing overpriced bonds in customer accounts.] After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?” the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.
The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond. I said yes, and he made me an offer several dollars above what I thought they were worth. With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still. He offered something close to the “more still” price, and I sold the block to him there.
As we were settling the trade, I asked him, “Why the great bid?” He said, “We need the bonds for retail trusts. They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds. If rates rise, they take the loss.”
Even on Wall Street, if you have a good relationship, you get an honest answer. That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.
There are many ways to frame the yield question at present, here are two:
- You are on a fixed income, and you are having a hard time making ends meet. Should you lend longer to earn more, go for lower rated credits, or do nothing?
- You are earning almost nothing on your money market fund. You need liquidity, but where else could you invest it?
I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that. So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years. As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.
But don’t reach for yield. Odds are, you will get capital losses great than the excess yield you hoped to receive. And remember this, don’t buy products someone else wants to sell you. Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income. They prey upon those who want more money, and are weak in their knowledge of how the markets work.
To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks. You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers. You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.
I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield. They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy. They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.
Anyway, enough for now — more later.
Leave a Reply