Thursday, August 25, 2016

The problem of reaching for yield - it often does not work

Lower rated bonds are extremely risky and are really not fixed income instruments at all; they are best described as “equities in disguise” or “equities with a coupon.” In fact, these bonds always end up trading at equity‐like yields (which translates into much lower prices and very high yields) when the market recognizes their subordinated, equity‐like character.

-Michael Lewitt, Sure Money credit specialist

The post-Recession mantra for investors in a low interest rate world has been to reach for yield as a offset for near-zero rates. The Fed implicitly wants investors to take on portfolio risk as a means of jump-starting investments, but unfortunately, reality is not so simple. Reaching for yield is thought by many as just obtaining more spread over Treasuries or yield from shorter-term maturities. 

The risk of grabbing for yield is just not that simple as described by Michael Lewitt, a long-time credit specialist. For lower-rated high yield investments, there is more equity-like risk which is not the same as buying high quality companies.  

While high yield as measured by the HYG ETF seems to be doing well in 2016, a longer time period tells a different story. Holding the high yield index would have been a loser for the last three years. In fact, the underperformance would have been the case for a five year and ten year holding period. Greater yield is not the same as higher return, and greater yield will not lead to higher return. The graphs comparing the HYG ETF (in beige) and the S&P 500 index (in green and red) tell the real story.

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