Musings on Yield

When I closed my piece on Warren Buffett’s Annual Letter, I ended with an important statement tat when I read it in the morning, I thought many would find it cryptic.  Here it is:

And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.  Yield is the decision of the company, but what you should  ask is what is the increase in value of the company.  Look for investments that increase your net worth the most.

And I would add “With an eye toward safety.”

When I say there is no such thing as yield, I am overstating a matter to make a point.

  • Will the debtor make the interest (or principal) payment?
  • Will the company pay the regular dividend?  Will they increase it?
  • Will you be able to hold the instrument so that you can realize the yield over the long haul?

During times of stress, yield has a nasty tendency to disappear, often with significant principal losses.  Thus I am skittish whenever I hear someone say that they need to get a certain yield.

Individuals and Institutions, for better, but usually for worse, often rely on getting a certain yield from fixed income investments.

  • If I don’t get this yield, I won’t be able to meet my monthly expenses.
  • If I don’t get this yield, my quarterly earnings will miss.
  • If I don’t get this yield, our ability to support our charitable endeavors will suffer.

Sigh.  Look, this could have been entitled “Education of a Corporate Bond Manager, Part 13,” but I didn’t because this is more broad and important.  It affects everyone.

Once there are no wages/nonfinancial profits, investors usually move into a yield-seeking mode.  I experienced this in spades for the insurance company that I helped to manage money for.

And yet, in the midst of the furor 2001-2003, we often acted against the insurer’s wishes in order to save their hide.  Particularly me; I could not bear doing the wrong thing, thinking that I would have the failure of an insurer on my conscience.

So in the midst of the nuttiness of 2002, I often did up-in-credit trades, reducing complexity trades, etc., when the market favored it.  Lose yield, gain safety, when the market is hot.  (Not when it is cold.)

I preserved the capital of the insurer, and it survived.  I even made extra money for them in the process, which they wasted on writing underpriced annuity business.

There was no level of yield that could have satisfied that client, even assuming that we could get it with safety.

But now as I start my asset management business, I deal with clients that are aiming for a certain yield.  To my surprise, even my Mom, the one who taught me the rudiments of investing is seeking for yield now.

You might or might not recall that the fourth real post at this blog was entitled Yield = Poison.  There are times to look for yield, and times not to.  The times not to are when yields and spreads are low.  At such a time, the best decision is not to reach for yield, but rather to forgo yield and preserve capital.  Buy TIPS, foreign bonds, and move up in quality and down in maturity in dollar terms.

I did this for an internal client 2004-2007, and made money for them, but it was utterly unconventional.  They could afford to deal with my idiosyncracies, because they didn’t need a current yield.

So, as I move to offer a fixed income strategy, I find myself butting heads with those that want a reliable income from bonds, and other fixed income instruments.  I’m sorry, but preserving principal is more important than getting yield.  Far better to eat into principal a little when spreads are tight, than to meet the spread target and get whacked in the bear phase of the credit cycle.

So, do I have a market for such investing in bonds, or is human nature so unchangeably mixed up that there will be few if any takers for my fixed income management?  Sadly, I think the answer is the latter.

4 Comments

  • RedSt8r says:

    @DM
    Yields are low and spreads tight though 2/10 Treasury spreads are widening.
    I look at Japan as a guide to Bernanke’s future policy moves. If so, isn’t there a serious risk yields and spreads will remain low for a long time? How long can we eat principal waiting for yields and spreads to widen?

    Buying TIPS, foreign bonds, higher quality, shorter maturity: combine this bond strategy with an equity strategy to produce the total return and I’d be happy as a client.

  • Paul in Kansas City says:

    retail clients will want income so you may want to offer the “simple” approach of using a fixed income mutual fund. your fixed income strategy should be offered on your terms; over time you will obtain the sticky assets needed to manage in this manner. I full confidence in your strategy

  • Greg says:

    This yield problem is an expected consequence of Bernanke’s failed policy of keeping interest rates artificially low to bail out political cronies.

    Mr Merkel might be able to give more detail, but I have heard that most penions (and related insurance products) are still assuming a TRR (total rate return) of around 7%. While I am using the example of pensions, the same general argument applies to all retirement vehicles.

    The longest dated investment grade bonds yield at least 100bp below assumptions, never mind shorter / actuarial matched durations.

    To put this in simple English: there is absolutely no way to defease retirements at Bernanke’s artificially low rates.

    Savings rates were already too low going into the recession – there were news stories to that effect everywhere. Everyone was going to have to make “catch up” savings no matter what else happened.

    By artificially lowering interest rates, Bernanke made the required savings rate impossible to achieve, even if the economy had recovered quickly.

    I appreciate David’s comments about yield, but I think the search for yields is a symptom of a much bigger macro economic disaster

    The true cost of the Fed’s recent policies is that Baby Boomer retirements were postponed, if not canceled.

    Gee, I wonder why Bernanke didn’t explain that cost upfront?

  • Research1234 says:

    We’ve had a 30 year bull market in bond returns, with the result that yields are pretty much as low as they can go. This was preceded by a 30 year bear market. Hard to want to buy bonds, since history suggests that the next 30 years will be another bond bear market.

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