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,


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.


Defaults Signal Bursting Muni Junk Bubble on High-Yield Surge
Margaret Collins
Bloomberg, March 10 2010

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