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.
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
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.
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.