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.
The most interesting thing about those retail trusts stuffed with long corporates is that small investors actually require negative compensation for callability. A structurer of one of those things said that banks added the call feature to the trusts when investors clamored for something with shorter average life… not realizing that institutional investors actually demand compensation for lack of call protection.
It’s hardest to avoid the “yield poison” if you’re managing other people’s money.
If you avoid investing, you underperform your peers in the bull market. if you go short, you’re shorting the ability of the Fed to keep the market afloat and that takes some guts. Besides, you need to time the selloff to perfection, not easy to do as I discuss here http://www.macroresilience.com/2009/12/30/john-hempton-on-efficient-markets/ . if you go long and the market does indeed collapse, you’re probably out of a job anyway so who cares? the incentives really don’t favour a brave money manager!
although large portions of the credit market do look ridiculously expensive. despite recent selloff in sovereign credit here in Europe, corporate spreads are as tight as they’ve been all year.
The only free lunch in fixed income today are CD’s and money market accounts from banks and- especially!- Credit Unions. I’ve been in the business since the 1970’s, and have never seen retail bank/credit union accounts yield 150-190 bps better than Vanguard money market accounts until this past year. It’s completely crazy to have uninsured mutual fund money market accounts, or nearly any paper out to 3 years maturity when retail deposits pay more with FDIC/NCUA protection. The banks aren’t crazy, because the actual duration of a money market deposit can be very long if rates are kept somewhat competitive.
Alliant Credit Union’s products are a good starting point, but there are many others.
I agree with RichL. As a retail investor, Treasuries don’t hold much attraction when I can get a 4-year CD at the bank two blocks away that yields 30-40bps more than a 5-year Treasury. Our checking account yields about 2%, if we jump through some easy hoops.
I hedge the inflation risk with GLD call spreads.
MR, check out this post about PIMCO on Bloomberg:
http://www.bloomberg.com/apps/news?pid=20601087&sid=aCsYALmsTN_o&pos=3
They are cashing in on most risk sectors of the bond markets.
I know this sounds like a very unpopular thing to say, but The Fed’s decision to punish the saver is actually the right thing to do.
Now hear me out on this. I am going to make a moral and economical argument on why saver needs to be punished, but investers should not.
First, savers and countries practising mercantilist policies are really doing the same thing. Fundamentally, they creates a surplus for themselves, and forcing deficits on others.
Second, in an economic exchange, one person exchanges some assets of his with another asset from another person. That is what exchanges should be all about. Exchange of assets, not exchange asset into money as the ultimate goal.
When a person has a lot of savings, he has in effect, only performed half of the exchange. He exchanged his assets into money. But the economical activities has not been completed, unless he exchanges his money into assets.
Having lots and lots of transactions, it is difficult to tell, if the majority are complete transactions, or merely half transactions.
Morally, when one sells an asset to get money, there is an implicit promise to use this money to buy other things from the buyer. Without buying things from the buyers, no more further economic activities can take place. The current crisis is precisely that, the savers failed to honor the promise to buy things.
Here is the difference between savers and investors. Savers hold on to money, while investors has already completed the whole transaction, and obtained a different asset, investment asset. One does not need to spend all income into current consumation. One can save, but must be in the format of asset, instead of money.
Investors can not cause a financial crisis, the saver caused it. And the normal way for a crisis to end, is when the saver obtained asset using their money. There can be two ways. One is savers willing buy assets, and the others is savers obtained the assets of the other side via bankruptcy. Mechancially, they are identical. Assets transfer hands, and money accumlated in the hands of savers vanished. Thus new rounds of economical activity can resume again.
The obligation of a seller to use the money obtain to buy things is taken for granted in economic theory. Any theory not directly using money is already assuming this to be the self-evident truth. But it is far from the truth. Thus rendering any theory based on this assumation irrelavant.
Of course the savers may never realize that they were actually doing this. They were taught saving is a good thing. They are saving for a future use. But a future use is meant to be used, not to be delayed into the future forever! Having money and never intending to use it, turns a saver into a miser.
As any economic textbook will say, saving money into the bank is not economical savings at all. So why do we still teach people to save in the form of money? Granted, people may not realize what they want to spend the money on in the future, thus retaining saving in the form of money. But this “option” granted makes it impossible for smooth economical progress, as the saver can always exercise the option, and never buy anything no matter what.
But the mentality the savers are right in not spending is the most difficult part in getting rid of recessions. Unless savers, in our case, China, cna be made to udnerstand why they are wrong, there can be no long term solution to crisis.