About all I hear these days is people complaining about low bond yields. A few of these folks – a precious few – have a point. Imagine that you’d diligently saved your money all your life, going without while others splurged. Now you’re elderly and living on the interest from your bond portfolio. That is, you were living on that interest. A few years ago the Federal Reserve decided to sacrifice you to help out the banking system, a sacrifice they felt to be well worthwhile. (Let’s hope that’s a minority opinion.(1))
But as for most of the rest of us, who own growth-oriented portfolios with equity allocations north of 50%, let’s get real. Sure, bond yields have been below inflation for quite some time. So? There are always parts of our portfolios that aren’t doing well, that’s just part of putting our capital at risk.
More important – far more important – the very same actions by the Fed that have destroyed bond yields (QE) have also juiced equity returns (QE). Since the Bear Market ended at the end of 1Q09, bonds are only up about 30% – really, not so bad. But stock returns (US stocks, which the Fed targets) are up 115%. Not so bad for an economy that is mired in the worst recovery in, well, history. So if you owned a portfolio that was 70% stocks and 30% bonds back in early 2009 and you didn’t rebalance (shame on you!), your overall portfolio is up roughly 90%.
How come I don’t hear people complaining about their great stock returns, courtesy of the same Federal Reserve? My point is, what the Fed taketh away (bond yields), the Fed also giveth (equity returns). So why in the world would people be “reaching for yield,” putting their bond portfolios at very serious risk once rates rise or spreads widen? It makes no sense.
But, wait! I hear someone rudely pointing out that the Moneybags©(2) sample portfolio has had a junk bond allocation for some time. True enough, but only in the opportunistic sector of the portfolio. Opportunities can arise in the capital markets for many reasons, but one of the best is “behavioral investment mistakes by people who aren’t us.”
It seemed to me (and to a bunch of other people) that lots of folks who were furious about low bond yields (even while their equity returns were being goosed) would “reach for yield” by buying junk bonds. That would push junk yields down and prices up, so why not take advantage of this opportunity?
If you’ve checked the Moneybags© portfolio recently, you’ll no doubt have noticed that the traditional junk exposure is gone, having been rolled into the leveraged loan portfolio. So many people reached for yield that junk yields are now at an all-time low (I’m talking about at least the last 350 years, since The Old Lady of Threadneedle Street(3) started keeping records). So what was once an opportunity is now a danger(4), and hence the allocation is history – take your profits and run!
Oh – about that leveraged loan allocation. Leveraged loans, aka floating rate loans, are close cousins of junk bonds. The same kinds of companies (weak ones) that issue junk bonds also borrow money from banks. These loans are packaged and sold to investors (it’s a cinch the banks don’t want to hold them), including hedge funds and mutual funds. Historically, leveraged loans offer slightly lower returns than junk bonds, but also less risk.
There are two characteristics of leveraged loans that make them interesting. The first is that leveraged loans, constituting senior secured debt, rank higher in the capital structure than junk bonds, and, therefore, recoveries in the event of default have historically been almost twice as high as recoveries on defaulted junk.
The second is that leveraged loans “float,” that is, the interest rate on the loans changes as interest rates change. When interest rates rise, people who own junk bonds still get the bad old rate and hence the value of their junk bonds declines, sometimes precipitously. But as rates change, so do the rates on leveraged loans, offering some protection against capital loss.
The key word is “some.” Most leveraged loans contain a so-called “LIBOR floor.” If LIBOR is at 0.30%, and if the loan is underwritten at LIBOR +3%, and if the LIBOR floor is 2%, then the yield on the loan would be 5% (LIBOR plus the LIBOR floor). However, the interest rate won’t adjust until LIBOR exceeds 3%.
The LIBOR floor feature means that leveraged loans won’t float as gracefully as many investors think they might, and it also makes the loans highly sensitive to spreads, not just rising rates per se.(5) When both yields and spreads are rising, leveraged loan investors should be running for cover. In other words, some time in the near future, Moneybags© is likely to be bailing out of leveraged loans, too.
But to return to my main point: bond yields are low because equity returns are high. The next time you think about complaining about low yields, and especially the next time you think about taking on more risk because bond yields are low, keep in mind that what the Fed taketh away, the Fed also giveth.
(1) I’ve already complained about the dubious morality of the Fed’s actions. See my post of 2/14/13.
(2) The Moneybags© mobile financial app is available as a free download at the Apple App Store or at www.MoneybagsApp.com. The sample portfolio is just that – a sample. It’s not designed to be an appropriate portfolio for any particular investor.
(3) As the Bank of England is fondly known.
(4) Rates are so low that many fragile, low-rated companies are selling junk bonds to pay dividends to the buyout firms that own them. What is this, 2007?
(5) In other words, leveraged loans are sensitive both to rising rates per se, and also to the difference between rates demanded of creditworthy borrowers and rates demanded of lower quality borrowers.
Next up: From Hot Wars to Cold Wars to Currency Wars
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.