To start July, we are introducing a series looking at common investor errors. This is the part two of ten. Yesterday, we looked at the impact of excess fees on performance.

In the current low rate environment, many investors make the mistake of reaching for yield. That is our #2 investor error after excess fees.

The first law of economics is there is no free lunch. You would think the mathematics of that would itself be a warning as to the perils of chasing the higher yielding paper, and that it should be self-explanatory. But its not

History shows us there are few investment mistakes more costly then “chasing yield.” Fixed income is supposed to be your safe money, what you have to have back, what will cushion the ups and downs of the equity markets. Hence, you should be first concerned with return of your money, and second, the return on your money.

In other words, safety first for your bonds and preferred.

Don’t take my work for it, just ask the folks who loaded up on sub-prime mortgage-backed securities for the extra yield how that worked out for them.  Some people have suggested I cut the RMBS investors some slack, as the paper was rated AAA. I don’t because they willingly violated the Free Lunch edict.

Quick war story: In 2004, I worked at a firm that was occasionally pitched products from other shops. One day, I walked into the conference room to hear Lehman Brothers offer a higher yielding fixed income product. “AAA rated, Safe as Treasuries, yielding 100-300 basis points more. I was subsequently called into my bosses office for saying:

You guys are either going to win the Nobel prize in economics or go to jail. There is nothing in between.” (Does a firm ending faceplant count as the equivalent of the latter?)

Regardless, we know the outcome of THAT free lunch.

There are three common ways to chase yield: 1) Go out on the duration curve, i.e., buy longer dated bonds; 2) Go down the credit scale, i.e., buy junkier, riskier paper;  or 3) use leverage, which amplifies your gains but also amplifies your losses as well.

With the 10 Year Treasury at 1.6%, I see lots of folks trying to capture more income using some combination of the above. Anyone who engages in this sort of ill-advised risky behavior should best understand the risks you are taking, and what that might mean if and when things go awry.

Simple rule of thumb: Never reach for yield.

~~~

What are you chasing for Yield?

 

 

Previously:
Top 10 Investor Errors
1.  Excess Fees

 

Top 10 Investor Errors
1. High Fees Are A Drag on Returns
2. Reaching for Yield
3. You (and your Behavior) Are Your Own Worst Enemy
4. Mutual Fund vs ETFs
5. Asset Allocation Matters More than Stock Picking
6. Passive vs Active Management
7. Not Understanding the Long Cycle
8. Cognitive Errors
9. Confusing Past Performance With Future Potential
10. When Paying Fees, Get What You Pay For

Category: Apprenticed Investor, Investing, Rules

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

31 Responses to “Top 10 Investor Errors: Reaching for Yield”

  1. Chief Tomahawk says:

    “Does a firm ending faceplant count as the equivalent of the latter?”

    I think should be edited to include: “Does a firm ending faceplant and unprecedented bailout of the world’s financial system count as the equivalent of the latter?”

  2. jpmist says:

    While I agree with your article, I have to submit one exception- Agency Mortgage REITs. They basically function as banks except the assets they buy are government backed agency mortgage notes. Annaly has consistently yielded more than 10% for over 10 years even during the Lehman collapse. Annaly’s total return since inception is about 7 times the S&P.

  3. DeDude says:

    It is one of the things that worry me. A lot of small investors actually need to have a certain income from their small nest eggs. With safe investments yielding next to nothing they may face the choice between food/meds or taking higher risks (whether they know the risk or not). That can only end bad.

  4. Drizzt says:

    at the end of the day if market is efficient the yields reflect the adequate compensation for the risk borne.

    your job as an investor is to uncover safe high yield mispriced temperory at lower price.

    i share a similar concern in that while i am not based in US, i used to be able to uncover 7-12% yielders that trades at a lower price. not so this 3 months.

    its like all over the world the people are reaching for yield

  5. Drizzt says:

    i would like to throw something out. The textbook good yields are definitely the low payout high yielding blue chip stocks that pays increasing dividends probably like vodafone.

    however, there are many segments that i find it questionable even though its legit

    REITs – a high yielding asset class that has to pay out large amounts yet when need of expansion always needs a cash call

    Dividend Stocks that pay out of free cash flow when depreciation > capex – these sounds like self liquidating assets

    although they look legit but ultimately they may not be good for investors in the long run

  6. Bam_Man says:

    But…but…isn’t our “hero” Ben Bernanke forcing us to reach for yield by artificially lowering interest rates on “risk free” assets such as deposit accounts and all but the longest-duration US Treasuries?
    Or maybe I am just missing something here and need to be “enlightened”.

  7. ToNYC says:

    What’s not to like if reaching with a collar; selling OK performance calls and buying the puts?
    NSAs not applicable.
    No collar, no dancing tonight.
    ZIRPs makes retroZerfs of savers of stored consumption.
    “Federal” Reserve GMO money needs Terminator gene or US don’t pass Go.

  8. just-sayin says:

    I am with you ToNYC.

    I have been mainly buying into ETFs (but ready to sell them too if need be) that invest in Corp Bonds and Preferred Shares and
    in setting up collars on good yielding stocks.

    I am expecting a big market letdown sometime before November…but
    hoping that it doesn’t happen.

    Be careful out there folks…..

  9. marianlibrarian says:

    I have read at least two recent articles recommending single family residences as investments as “there is no where else to put your money.” I have to say, I trust myself managing a couple residential properties more than I trust the CEOs of the Fortune 500.

  10. mbreuter says:

    Small holding in NLY, which seems like a better idea than a large holding in Treasuries. With so many investors piling into bond funds, maybe “reaching for safety” is just as big of a mistake these days.

  11. Joe says:

    Given that bonds and savings have become “return-free risk” as the Fed has tried to make hiding out until the financial crisis and it’s after effects is over untenable, savers and risk adverse investors have been squeezed hard for years . If then, it turns out that the Fed has merely stretched out and delayed the inevitable bloody resolution of the crisis and if a collapse in Europe sets off a period of steep deflation and domestic write offs , could the US be looking at a “revenge of the savers”, where those left with liquid assets will get a once in a life time chance to buy at the bottom? Or will a world wide crash be equally damaging to those with cash flows and savings?

  12. EdDunkle says:

    Can’t you hedge dodgy corporate bond funds by buying bear bond ETFs like TBF? What am I not understanding here?

  13. RW says:

    Let’s connect a few dots here:

    jpmist intimates that agency mortgage debt now has the full faith and credit of the US behind it which means savers could be getting much higher yields than they receive from guaranteed deposits in banks and from T-bonds. I certainly can’t disagree because I’ve bought and hold both AGNC and it’s new cousin.

    Others note that in a very low interest rate environment, savers are being punished if they play it safe.

    These sound contradictory but are not: The actions of lawmakers and the central bank have vastly expanded the domain of guaranteed assets but even that would not be sufficient to satisfy the need for safe assets in the current environment if everyone tried to acquire them.

    But frankly most savers probably do not know where to find higher yields (other than by taking on more risk) in any case: call them “naive savers” if you kuje — but in time they could probably figure most of it which would make assets with higher yields more expensive yet.

    However naive savers are not simply being hit with the lower return from safer assets and the reduced income stream that implies, they are unlikely to benefit much by figuring out how to boost yield “safely” as the less naive now do with assets such as agency debt.

    The reason is taxpayers are already paying the cost of making risky assets safe and, eo ipso, for the low resulting rates and their lower returns.

    And on top of that they are paying to reduce the level of economic innovation while empowering the brand of crony-capitalism that have every reason to maintain things just as they are.

    The argument can become rather arcane — this post by Rajiv Sethi has all the essential links and the comments that follow, particularly those of “paine,” limn critical points — but at the risk of considerable oversimplification this excerpt (from a link) lays out a critical element:

    The very act of making private sector assets “safe” is a transfer of wealth from the taxpayer to some of the richest people in our society. The explicit nature of the central banks’ stabilisation commitment means that the rent extracted from the commitment increases over time as more and more economic actors align their portfolios to hold the stabilised and protected assets.

    Such a program is also biased towards incumbent firms and against new firms. …any long-term macroeconomic stabilisation program that commits to purchasing and supporting macro-risky assets will incentivise economic actors to take on macro risk and shed idiosyncratic risk. Idiosyncratic risk-taking is the lifeblood of innovation in any economy.

    Shorter me: Trying to solve the crisis by working through existing financial institutions may have stabilized the initial situation but continuing it punishes taxpayers doubly and makes perverse outcomes (coupled with increased moral hazard) not only virtually certain but resistent to future change. JMO

  14. RW says:

    Well, my previous comment was fairly incoherent even for me but (a) I do recommend Sethi’s post for those willing to think the problem through and (b) it is possible to make the point a whole lot shorter and much more directly:

    We wouldn’t be worried about searching for yield now if every citizen just got a huge cash gift directly from the Fed and kept getting it until employment were back to normal.

    Yeah, I know, legally and politically impossible but it would have solved the entire demand problem right then and there and, along with it, the output gap and unemployment. Just say’n.

  15. katland says:

    “More money has been lost reaching for yield than at the point of a gun.”

    –Raymond DeVoe, Jr.

  16. Jim67545 says:

    The yield on corporate bonds is pretty much related to the rating from S&P et al. If you spread and analyze the financials of these firms you will find situations where you disagree with the rating agencies by maybe two notches (and here I am talking BBB- vs. BB, for example.) Maybe the issue has not been re-rated lately. Anyway one can pick up a bit more yield by doing this homework. Don’t find much worthwhile BB- and below, though. Warts and issues. So, occasionally yield is not perfectly related to risk and you can score higher yield with lower risk.

    MLPs seem to be unusually high yielders. The only explanations I can see is that they are mistaken for their extraction company customers and there are some income tax complications. Some have same problem as REITS, noted above.

    Preferreds have offered higher than average yields. If the underlying company is strong and worth owning you might get 5.5% on the preferred vs. 2.5% on the dividend. But research the terms of the preferred. One source is http://www.quantumonline.com. Enjoy.

  17. end game says:

    Reaching for yield is the critical mistake that I see nearly all investors making now. If you believe, as I do, that a breakup of the euro is fairly inevitable, which would cause a financial crisis in Europe and a recession in the U.S., then you must own US Treasurys as your only diversifying asset to offset the 30% or so downside potential in your risk portfolio, which includes equities, hedge funds, MLPs, converts, high yield bonds, high dividend stocks, and, yes, mortgage REITs, all of which are highly correlated to equities over the past few years. Even if yield vehicles only fall 20% or 25%, how is that worth the extra 3-5% in distributions?

    Regarding NLY, I own it, and if you ignore the leverage inherent in their business model, the downside move that it could make if interest rates rise sharply would take your breath away.

    Regarding dividend stocks, how do you think they would fare if taxes on dividends rise from 15% to 39.6% on Jan. 1, combined with aanother financial crisis caused by a euro breakup? The only diversifiying asset now is Treasurys, which have a negative correlation to risk assets. The more conservative you are, the higher your allocation to Treasurys should be.

  18. BennyProfane says:

    There’s a ton of “investors” reaching for yield in the home rental market right now. My guess is, that in four or five years, one will read how that didn’t work out too well when many couldn’t stand landlording with a 7% return, and the POS homes they bought didn’t double in value as they thought they would.

  19. machinehead says:

    There are three common ways to chase yield: 1) Go out on the duration curve, i.e., buy longer dated bonds; 2) Go down the credit scale, i.e., buy junkier, riskier paper; or 3) use leverage, which amplifies your gains but also amplifies your losses as well.

    Sticking to method #1, going out on the duration curve is exactly what you want to do when rates are falling. And when they’re rising, you scurry to safety on the short end of the curve, or in TIPS.

    Deciding where to position on the duration curve is what fixed income managers do. Unfortunately, their methodologies seem to reside mainly in their own heads. They pen lovely post facto anecdotal accounts of why they did what they did, which aren’t much help to you and me.

    So I’ve developed a killer bond model (which I will refrain from calling ‘Bill Gross in a box’) to automate this process, with startling results. Watch out, world!

  20. AHodge says:

    i like the drift generally for the beginners
    but i think you meant
    there are three ways for muppets to chase yield

    i object to even talking about yield on mortgage backed, there is no hold to maturity. its a complex product that few pros even understand
    in spite of it being large fractions of many portfolios
    its fake by real fixed income standards

    chasing real fixed income yield in a panic is excellent
    this could be near the worst time cyclically to chase yield
    the best time is in a total panic
    where the pros wont even touch stocks are picking up yield of the actually near safe
    Sept 23 2008, i am trying to pick up some Goldman bonds at over 9%
    i see Buffett doing the same i immediately pay the offer
    a quiet and subtle but beautiful trade
    never say never for these
    I dont
    i earned 9.2% and sold at a real nice capital gain one year later
    Munis were outstanding then also–worked for me
    early anxious downcycle might be the worst time like now
    late soiling pants screaming wont touch stocks panic can be the best time
    where by then you might also have sorted what is actually likely to survive

  21. ezrasfund says:

    I must confess to holding corporate bond funds like LQD and HYG. If you don’t intend to cash them out and just ride the wave and collect the dividends the risk/reward seems reasonable. Even in Oct 08 and Feb 09 these bounced right back from the dip and continued to pay a consistent dividend. Even with the HYG junk, when the likes of Sprint, First Data, Ally and Citi all go bankrupt the living will envy the dead.

  22. Iamthe50percent says:

    Bonds at historically low yields are so near a cliff that only pros should hold them. Safe short duration bonds yield so low that you might as well hold cash.

  23. louiswi says:

    RW makes some very good points here.

  24. [...] Why reaching for yield so often leads in disaster.  (Big Picture) [...]

  25. AHodge says:

    I like Rw and sethi also. A lot.

  26. CANDollar says:

    I’m getting tired of analysts comparing dividends with treasury yields.
    So you buy a 10 year at 1.5%. You have a guaranteed cash flow stream and return of capital.

    So you buy a stock or stock index with a 3% yield. You also have no guarantee on cash flow and you could have a drawdown of 30% or more within the year (that requires a 43% capital gain to get back to zero).

    Dividend stocks are not the same as treasuries!!!
    Have some but have some bonds as well. Balance.

  27. CANDollar says:

    I’m getting tired of advisors comparing dividends with treasury yields.
    You buy a 10 year at 1.5%. You have a guaranteed cash flow stream and return of capital.

    You buy a stock or stock index with a 3% yield. You also have no guarantee on cash flow and you could have a drawdown of 30% or more within the year (that requires a 43% capital gain to get back to zero).

    Dividend stocks are not the same as treasuries!!!
    Have some but have some bonds as well. Balance.

  28. [...] Previously: 1. Excess Fees 2. Reaching for Yield 3. You Are Your Own Worst Enemy 4. Asset Allocation vs Stock Picking 5. Passive vs Active [...]

  29. [...] Previously: 1. Excess Fees 2. Reaching for Yield 3. You Are Your Own Worst Enemy 4. Asset Allocation vs Stock Picking 5. Passive vs Active [...]

  30. [...] 4. Income/Yield: You can create a yield/income portfolio, but only if you understand there is more risk involved and are willing to accept the loss of principle. (See this). [...]