The Dilemma of Adding Yield

Back when I was exclusively a bond manager, 2001-2003, which I chronicled in my series “The Education of a Corporate Bond Manager,” I successfully struggled with one concept: when do you try to add more yield to your portfolio, and when don’t you?

This is a tough question, because in the short run, it almost always makes sense to add yield to any portfolio.  Additional yield seems like free money.  What’s worse, your sales coverages at the major investment banks are programmed to offer more yield, so what do you do?

I had to learn the hard way myself, with few to teach me.  There are two aspects to this question: the micro, and the macro.

Micro

Know how to compare bonds so that you are able to figure out what a good swap is.  Thus you must understand:

  • The yield gained for illiquidity — public, 144A, private.
  • The yield lost for size — micro, small, medium, large.
  • The yield gained from duration — what is the proper yield give-up for investing “x” fewer years?
  • The yield gained from going down in credit — what names are mispriced, and offer value, though lower-rated?  What is the proper yield give up at various ratings, and how do you adjust them to reflect reality?
  • The yield differences regarding premium vs discount bonds — this is a relatively simple one, as you can take any spread of a bond over Treasuries, and recalculate it to be the spread against a par bond.  You’d be surprised how few people do that.  As a result two things happen: people buy expensive premium bonds that look cheap but aren’t, and some firms never buy premium bonds, even in cases where it makes sense.
  • The yield change for optionality, whether positive for puts, or negative for calls.
  • The yield differences across industries
  • The yield differences across special names — there are always a variety of names that trade wide or narrow — consult your analysts to understand which ones are mispriced.
  • The risk of a “special situation.”  Why are you the smart one, and others not?

Macro

This is the risk cycle. Think about:

  • How quickly are deals completed
  • How tight is the pricing in new deals
  • The tone of voice from your brokers
  • Your intermediate-term view of economics — if things are getting better be bullish, if worse be bearish.
  • Failures. Be wary as they begin, but be a buyer when you think things are at their worst. You will get the best prices for the recovery.  Few do this.

As a Wall Street Journal article pointed out, many bond mutual funds are reaching for yield now.  This is a time to be wary, but if you are playing for the end of cycle we aren’t there yet.  We have not had a significant default, or a series of small defaults.

So be on your guard, I am neutral at present, but I am watching for items that would make me more bullish or bearish.

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