Reaching, Once Again, For Yield
“People are starving for yield because rates are at zero. They’re taking more risk than they think.”
-Paul Tramontano, Constellation Wealth Advisors,
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One of the factors that caused the great credit crisis to spread far and wide was the “reach for yield.” This is one of the most expensive ways a fixed income investor can obtain a higher potential return on their bond investments.
Note that I used the term “higher,” not “better,” and the word “potential,” not “actual.”As we have seen, high yielding junk paper often goes bust, making the yield grab an exercise in foolish futility. Thank goodness bond investors learned their lesson in the credit collapse of 2008-09.
Only not so much.
In 2009, bond buyers poured $7.8 billion into higher-yielding municipal bond funds, more or less ignoring the precarious financial conditions of cities and states.
Rather than accept ultra low yields as a consequence of Federal Reserve action in 2001, bond buyers poured into various mortgage backed securities. Even though they were paying 250 to 350 basis points more than Treasuries, they were rated the same: AAA.
This time, they are eschewing the fraudulent AAA ratings from Moody’s and S&P, and instead are buying naked junk. The bet is that the cities will be bailed out, and their grab for higher yield will be safely rewarded.
This is MORAL HAZARD writ large. Bailouts encourage irresponsible behavior, as their are no negative consequences.
Here’s Bloomberg:
“High-yield municipal bonds rated BB+ or lower by Standard & Poor’s or Ba1 by Moody’s Investors Service, 10 levels below investment-grade debt, have returned about 31 percent in the last 12 months compared with 11 percent for investment-grade municipal securities, according to the indexes from S&P/Investortools.
U.S. state and local government tax revenue fell 6.7 percent as of September from a year earlier, marking the fourth consecutive quarter of decline, according to a December Census Bureau report. That may drive defaults higher this year and next, according to Moody’s, which didn’t provide a number. The New York-based company also said it expects “somewhat higher rates of default” among bonds not rated and those below investment-grade.”
Investors in these funds would do well to remember that Return OF Capital is more important than Return ON Capital.
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Source:
Defaults Signal Bursting Muni Junk Bubble on High-Yield Surge
Margaret Collins
Bloomberg, March 10 2010
http://www.bloomberg.com/apps/news?pid=20603037&sid=a.5zaTTL2AMs
March 10th, 2010 at 7:28 am
that’s a logical response too zirp, punish the non-consumers and prudent, support the growth
March 10th, 2010 at 7:40 am
Barry,
Bailout Nation did a great job pulling this issue together in a way I could explain to a layperson.
How are endowments pensions ec… that are risk restricted explaining this away? Or do you just get to make up your own rating now.
March 10th, 2010 at 7:47 am
BR,
nice post, nothing, really, needs to be said..
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for additional anecdote:
“…April’s sales-tax check will be particularly telling because it was April 2009 when the city’s downward spiral began, Kier said.
“We need to get closer to leveling off,” he said. “If we continue to drop 10 percent or more this April, and that’s on top of our decline last April, that would be a sign that we’re not finding the bottom yet.”
Tulsa’s March sales-tax payment, including interest, from the Oklahoma Tax Commission was $14,945,912, compared with $16,903,291 last year.
The revenue was collected from Jan. 16 to Feb. 15.
Overall for the fiscal year, which began July 1, the city is down 11.1 percent in sales-tax revenue, or about $18.3 million.
Use-tax revenue is down 14.3 percent or $2.2 million.
A budget amendment that reduces the general fund’s revenue intake by $10 million is still pending with the City Council….”
Read more from this Tulsa World article at http://www.tulsaworld.com/news/article.aspx?subjectid=334&articleid=20100309_11_A1_Tulsas644409
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stories, such as above, are legion–from Coast-to Coast-to-Coast..
good thing the CDS ‘Market’ is, still, opaque, as ever..
wouldn’t want to be ‘leaving footprints in the Snow’, so to speak.
March 10th, 2010 at 7:54 am
Rule numbers one through three for bond investors, be sure you will get your money back.
March 10th, 2010 at 7:56 am
Agreed, verynice post, but I also have to say the watching high yield corporates have one of their best years ver, while sitting virtuously on the sidelines, has been rough. It’s certainly long-term prudent but I can’t say I’ve enjoyed it!
March 10th, 2010 at 8:14 am
Attribution: I am more concerned about the return OF my money than the return ON my money. –Mark Twain
March 10th, 2010 at 8:38 am
Barry–
Don’t think it’s just individuals. I assume you saw the article at the link.
http://www.nytimes.com/2010/03/09/business/09pension.html?th&emc=th
March 10th, 2010 at 8:46 am
Bah… this is silly nonsense.
First — rating agencies have shown themselves to be worthless. IF anything investors followed rating agencies too closely in the prior cycle, investing in “AAA” securities that were not quite AAA.
Second — There is a BIG difference “reaching for yield” at 250-350 bps… than 6 bps AAA Subprime tranches. “Risky” debt has consistently been a good investment over cycles. While the downside risk has tended to be just as high in “safe” debt. It is a great financial truism that “risky” credit is overpaid for. Milken is the modern multi-B-aire off this mistake, many followed in each cycle. You make it again here.
Third — Municipals do not go bankrupt. (Very very rarely). And its a classic case of something at its bottom. Tax recipts tend to recover dramatically in recovery, but they lag. Why is this not saavy investing?
All investing is at the core an act of “future prediction”. The future is uncertain. ALL investments have risk. But this article has as “pretense” that there are obvious rights and wrongs (like paying attention to ratings, and staying “safe”). This is NON-SENSE. Those lessons would’ve cost investors far more in the last year of recovery, than they ever would’ve lost in the downturn.
Good investors look for risky investments with highly skewed reward potential. Not “100% safety”.
March 10th, 2010 at 8:51 am
BR sez: “This is MORAL HAZARD writ large. Bailouts encourage irresponsible behavior, as their are no negative consequences.”
And so let’s look at how harshly MORAL HAZARD has been punished, along with those who chose to ignore it … over the past year or two, have we seen:
*) more than a token Wall Street firm (or two) get their just desserts?
*) any significant reduction in the pigs at the trough compensation levels of the people taking the most risk?
*) any signs of significant taxpayer revolt — as we have in Iceland or Greece?
*) any significant scurrying of the cockroaches in Congress, as the lights are turned on regarding their complicity in the mess?
*) EVEN A SINGLE significant reform enacted in the financial industry?
*) anyone besides Madoff doing jail time? (the senior staff at GS, MS, BoA, C have committed far greater thefts — Madoff’s mistake was in not going directly to the feds for a bailout when he began to suffer cash flow difficulties)
yawn. Moral Hazard is the new normal. (same as the old normal)
March 10th, 2010 at 9:00 am
@cognos 8:46 am
“Municipals do not go bankrupt. (Very very rarely). And its a classic case of something at its bottom. Tax recipts tend to recover dramatically in recovery, but they lag. Why is this not saavy investing?”
THANK YOU SIR! Funniest thing I am likely to read all week. What state do you live in, sir?
March 10th, 2010 at 9:15 am
States that cross some threshold will get some type of bailout by the federal government. what they need and how they get it is the unknown. No one in Congress is going to let California self-implode, even if the imbeciles running the asylum stab their own feet. The ‘bailouts’ in whatever form they take are comnig. There are many states that are in dire fiscal condition and I expect the next 2 state budget cycles to be very painful.
March 10th, 2010 at 9:24 am
I should point out that cognos is correct, over the past half-century of investing history, when we had regulatory safeguards against complete insanity on the part of the financial industry, and when (some) politicians were concerned about running deficits that were too large for the system to indefinitely support.
But if you go back before that half-century, you will find municipalities going broke on a quite regular basis, with bond issues that are funded by direct economic activity (toll roads, airports, etc) being much more desirable than indirect revenue (school bonds, that sort of thing) — for THAT VERY REASON. Cities ran into serious financial difficult at every economic collapse, prior to the regulatory constraints being placed upon the financial sector during the GD.
If one looks at where the employment comes from in this great (?) nation, it is coming from small businesses, and to the middle classes, where there are (or used to be, in any event) the bulk of the employable people.
Today, small businesses are struggling to breathe, with no credit for operating capital forthcoming from the banks, and no sales coming from their customer base. Those are the same jobs that fuel state & city tax coffers.
Or fail to fuel them, in this case.
While census jobs may improve the BLS stats for a while this year, the underlying problems are not being addressed, and when the census job tides retreat in the fall, so will the illusion of employment, and the conduit from federal borrowed money to the states will have to be replaced by something else.
The TRUE NEW NORMAL, as nearly every financial sage has written, will be a lengthy period of sheeple struggling to keep their heads above water, with no great surge of income to lift them out of the swamp.
The big companies will do OK, as their income does not depend (for the most part) on consumer purchases, but rather on government and corporate spending — which is proceeding apace, at least from the government. Thus we have the bifurcated economy, typical of a banana republic, with a small very wealthy minority living in splendor and comfort while the masses (those who used to make up the middle classes) struggle to catch a break.
The economic turnover between the wealthy and the middle classes has ceased to function in this republic, where folks in the middle classes could aspire to rise up the economic ladder if they worked hard and were successful, replaced by a class warfare that the middles were ill-equipped to fight, not having personal lobbyists to bend Congress and the tax code to their liking.
March 10th, 2010 at 9:46 am
From what I’ve read, pension funds, etc. have assumptions of 8% or so returns built into their models, so it seems they have no choice (other than cutting payouts).
March 10th, 2010 at 9:54 am
During expansions, five-year Treasury rates have historically tracked fairly closely to nominal growth, that is, growth not adjusted for inflation. In the long run, nominal growth and long-term rates tend to converge. While the correlation between the two is far from perfect, particularly in the short run, nominal growth expectations can provide a general guideline for our rate projections. Given the dismal levels of growth notched during the depth of the recession, our forecast is comparatively quite robust. It follows that rates ought to increase significantly over the same time horizon.
Indeed, the 10-year Treasury yield will likely double from the lows of the recession to the end of 2011, due at least in part to much improved economic growth. The path of GDP growth has traversed across an extremely broad swath of territory, which is common when transitioning between economic cycles. Rates have done the same. Extremely low as the flight to safety trade was in play, they have since begun to normalize. In this paper, we will review growth, inflation and market fundamentals to determine what they reveal about future rates.
March 10th, 2010 at 10:12 am
Rikky:
But, who is going to bail out all the municipalities, school boards and other municipal entities who have seen a huge cut in their collections and would be in trouble if collections had only stayed flat. It’s pretty universal that they all have overobligated themselves on services and pensions and there is no way they can meet those obligations without tax increases higher than residents will accept. If these wind up in bankruptcy, the bondholders will have to take a haircut. I was impressed that the new mayor of Houston acknowledged the problem (thought not quite as gloomily) when she first took office. There’s a limit to what the Feds will be able to do.
March 10th, 2010 at 10:43 am
[...] Alphaville rather liked this comment from Barry Ritholtz on emerging signs (well, screaming fire alarms) of a US municipal junk bond bubble: One of the [...]
March 10th, 2010 at 10:46 am
@ John Silvia
Historically there appears to be an interest rate cycle that last ~ 60 years ( 30 up / 30 down +/-). It would appear that we are at/near the bottom of that cycle and should be looking for ~ 30 years of increasing interest rates (with normal ups and down overlaid on the broad trend). Does that factor into your analysis at all, that is beyond the normal recovery move?
March 10th, 2010 at 11:15 am
Mr. E –
Why would you say this – “appears to be a 30/30 cycle”?
Going back 300 years do you see 10 cycles? Going back 150 years do you see 5 cycles? We see 1, maybe 2 moves that look like that. Its like seeing something in the clouds… or “Jesus” in a piece of toast and then buying it on Ebay.
Moronic.
March 10th, 2010 at 11:48 am
@ cognos
1. “Municipals do not go bankrupt. (Very very rarely). And its a classic case of something at its bottom. Tax recipts [sic] tend to recover dramatically in recovery, but they lag. Why is this not saavy [sic] investing?”
You are correct, but there are defaults on municipal bonds that have little to do with bankruptcy. The rates of default are typically low by comparison to corporate bonds. However, according to a series of studies by Fitch Ratings (1999, 2003, 2007), ‘municipal default rates do go up moderately during recessions, particularly in the year after the economy bottoms out.” So if I understand your premise, you believe buying unrated or below investment-grade muni’s, as we come into a period that historically sees higher rates of defaults on muni’s, to be a reasonable investment practice?
2. “Why would you say this – “appears to be a 30/30 cycle”?”
My statement came from using 109 years of data, source Ed Easterling, Crestmont Research. Your source?
March 10th, 2010 at 11:48 am
Old brokerage truism: Yield hogs get slaughtered.
March 10th, 2010 at 12:00 pm
It’s times like this that I’m thankful I’m a small, nimble trader that can get my yield from places the elephants could never dream to reach
March 10th, 2010 at 12:27 pm
Correction to previous reply to cognos …
2. “Why would you say this – “appears to be a 30/30 cycle”?”
My statement came from using 109 years of data, source Ed Easterling, Crestmont Research. Your source?
Correction – my source was the online data from Prof. Robert Shiller, which has now been updated going back to 1870. Easterling (Crestmont) is another source and uses Shiller’s published data and others on his website.
I sometimes loos track of where I get things and what I analyzed when.
March 10th, 2010 at 12:51 pm
[...] for yield almost ends badly. (Big Picture also FT [...]
March 10th, 2010 at 1:29 pm
I bought muni bond funds during 2009 … but bringing my portfolio allocation only up to 15%. I plan on holding that 15% for years and years.
The thing I don’t like about the “oh look at the billions flowing” cries is that they kind of assume a sensible and balanced portfolio to start. Or they assume a high muni bond exposure at the end.
How many of these folks started at 100% equities and are still at 90% equities? If they just switched new 401k contributions to the munis, it’s possible
March 10th, 2010 at 4:38 pm
[...] ignoring “precarious financial conditions” of states and cities, Barry Ritholtz notes. “The bet is that the cities will be bailed out, and their grab for higher yield will be [...]
March 10th, 2010 at 11:43 pm
Not sure if others sense this same rumbling, but I’m beginning to think an avalanche of defaults is approaching. Sovereign, corporate and (yes) municipal loan defaults. I think it is time to step to the sidelines and hold a little more cash rather than credit. All this yield chasing in such a shaky economy scares the willies out of me……
I like Marcus Aurelius’ Mark Twain quote: “I am more concerned about the return OF my money than the return ON my money”. I”ll quote Shakespeare though I know he never said it: “Tis the quiet before the storm. Methinks I smell some deflation upon the still air…”