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Guest Post: Reaching For Yield And Clubbing Baby Seals

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Submitted by Peter Tchir of TF Market Advisors

Reaching for Yield and Clubbing Baby Seals

With Greece “solved” and economic data topping expectations we are back in full risk on mode.  Once again the quest for yield is on every fixed income investor’s mind.  Reaching for yield is when investors make an investment based on wanting more current income.  It may be a subtle differnce, but the mentality of someone who winds up investing in an asset become it meets there current income hurdle, is different than someone who found an asset where they believe the risk/reward is priced extremely attractively.  There are only 3 ways to increase yield:

  • Extending maturity, moving out the curve, getting paid more to take longer dated risk
  • Moving down the credit curve, investing in weaker credits
  • Investing in more structured products, the more complex a security, the more it has to pay investors to take that risk

So in any period of ‘reaching for yield’ the market sees a gradual shift as investors move out the curve, purchase weaker credits, or dabble in structured products.  These are not their usual “comfort zone” of investing.  Someone used to investing in 3 year risk, is not used to the volatility of investing in 10 year bonds.  The investment grade investor may not fully understand the convexity of callable high yield bonds, not the impact of secured loans above you in the capital structure.  Worst of all, the straight bond investor who takes a punt on some structured assets may not fully understand the asset and over estimate the liquidity in bad times by orders of magnitude. 

These shifts are generally very gradual. It takes investors awhile to get comfortable with the increased risk.  As the asset class performs, the investor is more confident in their decision making, and likely has even more need to reach for yield, so they add more money to areas outside of their core competency.  Then, one day, almost out of nowhere, something sparks a sell-off.  It is almost as though one day the asset class is great, the investor is smart, and the next day, the market is selling off and the investor has no idea why.  If it was an area they were experts in they might assess the market carefully and decide to retain their position, or even add.  But in a market that they don’t have much experience, the declining price creates fear, and ultimately, it is impossible for the investor who reached for a few extra bps to bury the sensation that they could lose far more money than they hoped to make.  Those few extra bps, which the investor viewed as so important, just a short while ago, were only available because this investment was MORE risky.  That risk now becomes too much and the investor joins the selling parade, creating a sharp sell-off.

Credit markets consistently show long, gradual, upward trends, marked by short, fast, and relatively large downward moves.  The reach for yield plays a large part in it, so it might be worth looking at some recent examples of how bad it was when the reach for yield investor got clubbed like a baby seal. 

The reason that the drops are so sharp is that there opposite of the “reach for yield” is “flight to safety”.  If it was “flight to relative safety” you would see a contained pullback.  Investors would move to slightly shorter maturities, or slightly higher up the credit spectrum, or into an asset slightly less complex.  But that is not how it works.  When the “flight to safety occurs” all these weeks, months, or potentially years of incremental risk just want out.  They want the 2 year treasury.  It is a gradual, incremental process while investors reach for yield, followed by a gut check and a risk off mentality, which usually makes the sell-offs so much more dramatic than rallies.

It is worth noting that the examples I have chosen don’t all overlap.  Some were relatively isolated and some came at times where other credit markets (and stocks) were experiencing sell-offs.  High Yield bonds seem to have the most trouble avoiding being dragged into credit problems in other markets.  That is likely because high yield is the ultimate reach for yield.  It is not quite equity, but is risky, and when liquidity evaporates in other high beta credit products, people sell high yield as a way to reduce credit exposure, and so they can shift assets into the newly higher yielding alternative bond market.  High Yield is a proxy market, almost a last stop hotel for most people.  It does best when the reach yield it at its peak mania.  Unfortunately, this means it has the maximum number of knowledgeable investors at the worst possible times, where the upside vs downside risk is skewed against the investors.

Greece 2007-2010

Look at the Greek 10 year bond that was issued in 2006.  What I find most interesting is how little it sold off on the back of the Lehman event.  It sold off sharply, undoing a year of price appreciation, but nothing like other credit assets sold off.  Then it steadily increased in price until Dec. 2009.  Then, almost out of nowhere, the bottom fell out of the market.  Investors were piling into Greece because it offered a pick up to German or French debt.  Investors wanted that incremental yield.  These bonds hit a multi-year high right before they were decimated.

GGB 3.6% 2016 from July 2007 to July 2010

Municipal Bonds 2010

Using the MUB etf as a decent proxy of the muni market, it is interesting to see what happened.  From early 2009 until September 2010, these bonds continued their gradual recovery from their post Lehman lows.  The gradual trend higher did have a couple sharp rises but these were followed by equally sharp declines so I have focused on the long term trend line.  What caused this sharp sell-off?  A sell-off that was completely isolated from other credit markets which were enjoying the QE2 inspired risk on trade?  Meredith Whitney came out and clubbed this market into submission.  I find this market move extremely interesting as Meredith didn’t have any prior experience in the municipal bond market that I know of.  A lot of experts had strong negative views on the market, but she threw out numbers that caught the media attention, and managed to almost single handedly crush this market.  Clearly there were conditions in the market that let this happen (there always are) but anyone who doubts that credit markets become illiquid far faster than they could imagine should stare at this chart for awhile before allocating too much money to riskier credit markets in their search for yield.

MUB April 2009-April 2011

ABX (Mortgage Market) 2008

First, I have to admit that I couldn’t find the data for 2006 and 2007.  ABX BBB’s had traded close to par until various shocks took them down to a price of 35 by the start of 2008.  When I could only find data back to 2008, I figured I had lost the opportunity to point out ABX.  To some extent, that is true, but even looking at the price action in 2008, of a dying or dead asset class is worthwhile.  The year starts with a sharp decline, followed by a small, slow rebound, followed by another drop.  Then just slow and steady until another sharp drop with Lehman.  People buying something at 35 at the start of the year were doing more than “reaching for yield” but I suspect a lot were people not familiar with ABX who felt it couldn’t go much further.  Well it did, and the pattern of periods of stable performance followed by sharp drops, is clearly exhibited.  The early data, particularly on AAA ABX fits perfectly and I hope I can find it soon to add, and that was a definite example of people chasing for yield by moving into more complex products.


ABX BBB S6-1 Jan 2008 – Jan 2009

CDX IG Index

This chart looks at the performance the CDX IG indices over time.  It attempts to adjust for the rolls so that it can be looked at as a continuous series.  This is in spread as opposed to price, so when it goes up, that is a time of credit weakness.  The same pattern of extended periods of gradual spread tightening followed by steep gaps wider is here as well.  You can see the initial problems in subprime starting in 2007 and culminating in the Bear Stearns bailout.  It was followed by another spike wider (that pre-dated Lehman, and even FNMA).  It is only fair to point out that there were 2 periods where the indices had sharp moves tighter, in contrast to the other credit markets.  That is a combination of the fact that government intervention was immense, and these are “hedging” products and “fast money” products, so the turns can be more dramatic as they face a much great squeeze pressure than “real money” or “retail investor” products.

CDX IG Generic Chart 2005-2011 Weekly

Emerging Markets

Here is just a quick look at one of the old Merrill Lynch Emerging Market bond indices.  I would have preferred to use JPM EMBI which is the standard benchmark for emerging market bond managers, but was unable to obtain it.  This is the price return of that index since inception.  Once again we have the classic pattern of a long period of relative stability followed by a short sharp price drop.  This drop was tied to Russia and to Long Term Capital. 

Investment Grade Bonds

We looked at investment grade spreads using the CDX indices earlier.  Here is the performance of a corporate bond index on a spread basis.  One of the problems with any historical analysis of credit is the data quality.  Even as recently as the 1990’s you have to take the data with a grain of salt.  A lot of the bonds are matrix priced – a fancy way of saying someone took a quick guess at the end of the day based on a couple of inputs.  One effect is that corporate bonds seem less volatile than emerging market bonds over the same timeframe.  There is an element of truth to that, but partly EM actually traded, so the prices were real, and the corporate market didn’t trade as much and many of the prices were “sticky”.  In any case, this data captures the broad moves over this time.  Here the spread widening periods were only slightly steeper than the tightening periods, but moved for longer time frames.  The first widening was Enron and September 11th.  The second followed WorldCom and widespread fears on names like Devon and Nortel.  The story isn’t quite as compelling on these charts, but  part of that is the data quality.  It is also a function that a move from 45 bps to 125 bps doesn’t seem like much, but if you owned a 5 year bond trading at 45 bps, and it moved to 125 bps, your mark to market was about 3 pts, or more than the spread you were expecting to make over the entire life.

High Yield Bonds over the long term

It would be wrong to not examine high yield.  If you look closely you will see the mini pattern of sharp drops after relatively long quiet periods.  It doesn’t show up as well on a monthly graph over almost 25 years, but it is there.  The pattern also appears in the longer term trends.  High yield does have the advantage of having had a few sharp rallies.  Much more so than most of the other credit products, but that is because the drops are higher than IG and unlike ABX the default rate even at the worst times was bearable.  We might be in store for a much longer continued period of stability, but history shows, that when people want out, they get out fast, and there is almost no one to replace them.  That is a problem with being a proxy for equities and the last hope of the yield chasers.  Once people don’t want equity and desire safety over yield, there is a big shortage of buyers.
 

 

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Sat, 07/02/2011 - 12:39 | 1421237 snowball777
snowball777's picture

Bathing in the effluence.

http://www.youtube.com/watch?v=m1xss8MlwCk

Sat, 07/02/2011 - 12:48 | 1421248 Piranhanoia
Piranhanoia's picture

There is a huge disconnect for "investors".  The people they purchase if from are now just like doctors and lawyers.  They only "practice" their craft. They are not liable, there is no guarantee of success, you pay either way, and there are limits to what you can do when they are sponsored by the government.

As investors remember you are dealing with bookies that also attempt to advise. The definition of investor will change in the lexicon before long. I have a few guesses as to the new synonyms.  They aren't complimentary.

Sat, 07/02/2011 - 13:36 | 1421301 Djirk
Djirk's picture

Any you punx remember rates in the double digits? Could happen again.

Now that is yield bitchez

Sat, 07/02/2011 - 13:43 | 1421306 kevinearick
kevinearick's picture

God’s Law:  The Eye in the Sky

The Internet is a symptom, an outcome of integral thinking. The most frequent mistake kids make, coming out of the derivatives box, is not casting aside all the bred-in false assumptions. Wealth is not a function of some great idea or plan, although they can be useful to get a start. Wealth is a function of exploration at the event horizon, trimming the sail, in anticipation of that which others cannot foretell. It’s like coming out of a life in the cave and training your eyes to filter the sun in a way that reveals its object. Most employ that gift to take moles from cave to cave.

Capitalism, like all isms, defines profit as the stronger party in a contract taking everything possible, while giving as little as possible. Everything after that is misdirection, to enslave children from birth, to the process. God’s law is the opposite. Give everything you can to the kids, and expect nothing in return, to distill an intelligent feedback loop, to the benefit of all, Democracy.

The church, and every other form of government, headed by Caesar, seeks to GRANT control, false power, to the weaker party, usually the female, due to physical limitations, but watch out. The Old Lady’s job is to coddle the children AFTER the old man kicks them between the shoulder blades, off a hill, specifically built for the occasion.

Caesar is extremely reluctant to f*** with the old man directly, because the old man is eventually going to drop the entire enterprise system right over the cliff. That’s History, the limit of what Caesar really knows. What the old man is anticipating is that the kids will have their bridge, the strait, ready to go, which appears to be an X on solid ground, because the inverted pyramid appears to have withstood the test of time. Relativity, time, is what you make of it.

You will notice that there is nothing in the standard marriage contract about government. It is a contract between you, your spouse, and God (glasses), to raise God’s children under the example of accepting social responsibility in return for the privilege of individual freedom, in a feedback loop. All powers not specifically granted to government by the people… Children are aliens, not stupid. Only Caesar seeks to breed stupidity, to the end of control, and the difference in participation is not difficult to distinguish.

Intelligent kids, by nature, are integral critters, and they will creep out to the edge of the cliff every time you turn your back. The old man waits until they get to the edge, thinking they have fooled him, when he gives them a swift kick in the back. When they are children, the cliff is a bank, with relativity, gravity, doing all the work. Eventually, the intelligent kids build a bridge for the occasion, which the old man “can’t” see. Those kids graduate. In Caesar’s world, the old man’s behavior is cruel and unusual behavior, and outlawed accordingly.

You have been given an eye in the sky, above Caesar, in anticipation of this occasion, a demographic crash. How you employ it is up to you. It’s a tool. Caesar will seek to turn it into a cave as quickly as possible, by all means. Encourage children to be independent from birth, in a small business built for the occasion, and everything else will take care of itself.

If you think you can do a better job than the old man, go out in the real world and do it. Don’t make some p**** remark on the Internet while you’re standing on an X built for the occasion. A dead body in a pool for 3 days … There is no lack of work. There is only a relative lack of parents, capable and willing to do the job in the face of Caesar’s tsunami. Architects travel in both directions, simultaneously, at all times, building the looking glass, which may be moved at will.

The coddling phase is over.

Happy Independence Day

Sat, 07/02/2011 - 15:51 | 1421478 ISEEIT
ISEEIT's picture

Well said. Although would it not be more eloquent to simply sum it up with:

Atrophy; meet entropy?

We have built our tower of babel. This was not for men to do. We are spiritual beings and will only be safe in spiritual persuits. Godliness is for God. I can no more be a Sun than can a Sun be merely me.

 

Sat, 07/02/2011 - 23:47 | 1422101 chalcedonite
chalcedonite's picture

"We are spiritual beings and will only be safe in spiritual persuits."

We are also physical beings that need air and water....  And there are many unsafe "spiritual persuits".

Sat, 07/02/2011 - 16:16 | 1421512 blindman
blindman's picture


i'm sure you are correct and accurate in your statement.
i have recently been considering the mind mining business ubiquitous.
the mechanisms of neuro-imprinted concept structure via symbol recognition
as it occupies attention / time. control of attention and therefore the
physical being and energy of populations. referring here to markets and
current events and the control of the past and future thru control of the
present mind set. so media, education, government , art etc.. (symbols).
now. we have the dissolution of attention, concentration via chaotic infusion
of information. global perspective injections, moshing time and perspectives.
the technology has out run the human spirit. the mind laid waste in the face of
confusion and complexity and moshed time/ perspective/ frames. this is the
beauty of the internet. virtual freedom. the freedom of a parasite. ongoing
.
but, friends and family, here is something else.
the individual is being rendered incompetent by the utilities emerged
to serve "them". the human spirit subverted to serve the mindless elements
of the system of fraudulence, for "fun and profit". how low can you go for
greater yield.
.
it would be funny if
it weren't true.
.
root problems result in
organic and structural collapse.
.
failure
is good.
( the dynamics of mind control and mining are ubiquitous and interesting
but too depressing and demanding to adequately articulate here. i'd say,
just, that it is like multi level chess and the pieces are narratives, in the media,
and peoples and energies, brought to light in timely fashion to distract attention
from the truth that is mixed in. so it becomes a question of accent, punctuation
and distraction. balance? ) the unknown that is right there in the back of your
mind, on the tip of your tongue, but you can't really recall.
.
out on a limb here but i would say this is why
"man" plays the banjo.

Sat, 07/02/2011 - 14:56 | 1421376 Downtoolong
Downtoolong's picture

I’ve always been a bit perplexed by the price behavior of high yield bonds, particularly the high yield bond fund I own shares in. The share price seems to correlate better with equity indices than they do with interest rates and less risky bonds. Interestingly, they have been the highest total yielding asset class I own since they hit their relative bottom in December 2008, by a margin of about 25%, which is precisely why I am in the process of gradually liquidating my position in them now.  

Better me first than you Ben Bernanke.

   

Sat, 07/02/2011 - 15:01 | 1421389 Caviar Emptor
Caviar Emptor's picture

It's not "Risk on/Risk off" in this economy. 

It's "Ponzi lives!/Ponzi dies!" 

Sun, 07/03/2011 - 09:23 | 1422402 Dollar Bill Hiccup
Dollar Bill Hiccup's picture

Yes, but with the subtle turn, "The Ponzi is Dead! Long Live the Ponzi!"

This is not a logic to be taken lightly.

Sat, 07/02/2011 - 15:01 | 1421390 FranSix
FranSix's picture

Negative interest rates.  Ahem.

http://youtu.be/GT86iWiH2mI

Sat, 07/02/2011 - 21:23 | 1421895 jm
jm's picture

I would like informed feedback to test these views.

There is no doubt that liqudity is more of an issue in this space.  This isn't radical or new... fixed income has always been like an OTC market and it doesn't work like equities.  So really "bidless" means something.  If you manage funding and liquidity, the "tails" are where you can make a killing in fixed income.

Greece has to roll the majority of their debt over the next three years, so these flare-ups, disclosures of Hellenic cheating on austerity terms, and countries that are on the stick for this stuff will vote out whole blocks of politicians responsible, all putting  this situation in jeopardy over and over again.  Don't see much good there, but it has done an amazing job at driving yield spreads in other, better European credits like Spain.    

In the muni space, if Meredith Whitney can ride a trick pony into a muni sell-off again, well that is one fool I want to see more of on TV. 

All these CDS indices, with due respect to Citadel, gloss over too many details about the intrinsics to which they are connected.  There are many distinct debt securities that can be delivered into CDS settlement.  So CDS often reflects credit risk in broad brushstrokes and neglects the details of a specific CUSIP. 

CDS can wag the dog a little in subprime because the non-agency market is busted and has yet to really function since 2008.  As a result of the Fed slowing down their unwind, ABX players hit the brkaes on Friday.  I'm guessing it will be a wild summer but there are some phenomenal opportunities here. 

Chinese interbank markets are signalling a hard landing.  A crashing China will kick IG in the balls.  This isn't reflected in spreads at all.

HY is going to be a pain trade.  HY has massive issuance in the pipeline in 2012.  Weakness in fundamentals as the slowing US economy gets discounted.  The end of QE2 will drive its equity character down.  Weakness in IG will drive its bond character down.    

Emerging sovereigns?  This index thinking is too cookie-cutter in my view.  You really have to account for the individual  context of sovereigns.  Everybody loves Latin America and it is easy to see why.  No value in Asia at all.  Emerging europe has had its run up. 

Bank debt in MENA looks pretty cheap.

 

Sat, 07/02/2011 - 21:41 | 1421925 oogs66
oogs66's picture

A lot to think about late on a Friday :) but as always some great points and great ideas

Sun, 07/03/2011 - 01:23 | 1422190 TimmyM
TimmyM's picture

jm both you and Peter neglect to talk about the elephant in the room.
Peter ignores the cause of yield reaching as FED policy. His yield reaching dynamic is dominated by moral hazard produced by the arrogant price fixing of overnight money. A free market in overnight money cures the hazard of artificial carry trading and curve intermediation.
Similarly, you look away from the risk premia compression created by ZIRP and QE-x. The market instability you both observe is fostered by excess liquidity. This liquidity introduces unnatural elements into natural pricing phenomenon.

Sun, 07/03/2011 - 09:02 | 1422390 oogs66
oogs66's picture

yes, the fed has pushed people into reaching for yield and i can't wait to see the excuses when this causes another big round of loss for bond investors.  i'm sure ben will blame it on someone else, but it is his policy that is skewing all investment decsions

Sun, 07/03/2011 - 12:16 | 1422556 jm
jm's picture

Totally right.

I've gotten away from hedging risk exposure, but I do hedge funding risk with eurodollar futures. 

Sun, 07/03/2011 - 09:08 | 1422394 snowball777
snowball777's picture

Agreed on every count save the usefulness of ABX or MENA investment...I wouldn't touch that crap with a bargepole.

China is doing a black swan dive into an empty dark pool; we're all at the mercy of their rickety internal debt structure.

I think HY and IG may get more love than you think, but only for a dearth of viable alternatives in the bond space.

Sun, 07/03/2011 - 11:28 | 1422567 jm
jm's picture

I respect your view.

Since the market is so busted, there's big risk in subprime.  Good or evil, I'm in.  Not much leverage in the position.

MENA banks look pretty good to me:  rising oil prices/stagflation, sovereigns with petrodollars can/will backstop, cheap valuation barring wholesale revolution.

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