The Aleph Blog » Blog Archive » The Dilemma of Adding Yield

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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Bonds, Portfolio Management | RSS 2.0 |

6 Responses to The Dilemma of Adding Yield

  1. [...] News flash: bond fund managers like to game their benchmarks.  (WSJ also The Aleph Blog) [...]

  2. intrlaz says:

    Great post. Could you explain the discount vs. premium math in more detail?

  3. [...] …but David Merkel explains why reaching for yield is not so simple, there are lots of considerations and a choice between risks.  (AlephBlog) [...]

  4. somrh says:

    One thing I’ve considered doing (and perhaps you have some better data series for this) would be to look at yield versus duration in a similar way that you do ROE analysis. It would be interesting to see if there’s any correlation.

    Here’s what I obtained using Vanguard’s ETFs:

    http://i7.photobucket.com/albums/y254/somrh/VanguardYTM-Duration_zps21dc7928.jpg

    I’d be curious to see how the slopes vary over time (and see how junk fits in as well).

  5. [...] Bonds and Credit Default Swaps at a Premium September 23, 2012By DavidMerkel TweetAfter my post last night, I was asked how I make corrections in analyzing premium versus discount bonds.  (Note: if a bond [...]

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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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