When Reaching for Yield Goes Wrong

August 7, 2014 10:00 AM

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“The market-formerly-known-as-high-yield’s average yield  fell to 4.9% as of the close of the day Monday, according to a benchmark Barclays U.S. high-yield index, while the equivalent Bank of America Merrill Lynch index fell to 4.94%, both new all-time lows.” – Barrons, June 17, 2014

“There is some evidence of reach for yield behavior.” – Janet Yellen, June 18, 2014

Fans of the hilarious and unfortunately short-lived Chapelle Show will likely recall a skit called “When Keeping it Real Goes Wrong.” The skit portrayed various situations in which, you guessed it, “keeping it real” went very wrong for certain characters on the show.

During the June FOMC press conference, for some reason this skit popped into my head, substituting the words “keeping it real” for “reaching for yield.” The press conference typically provides much comedic relief, but Yellen brought the house down when she said, in her best deadpan humor, that “there is some evidence of reach for yield behavior.”

Her delivery was perfect, a monotone intonation with just a hint of disbelief. In her standup act, Yellen presents herself as just another casual market observer. For the act to work, she needs the audience to believe that there couldn’t possibly be any link between the Fed’s policy of five and a half years of 0% interest rates (ZIRP) and a “reach for yield.” And even if there is a reach going on, we needn’t worry because there is only “some” evidence of it at this point.

Nothing to see here:

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“Some Evidence”

All of this is of course beyond hysterical. Even the most casual market participant can tell you that that saying there “some evidence” of reach for yield behavior is like saying there is some evidence of snow during a blizzard or some evidence of wind during a hurricane.

When yields on junk debt are at all-time lows and issuance at all-time highs, Ms. Yellen, there may be a bit more than some evidence.

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When covenant lite loans are accounting for 66% of leveraged loans this year compared with 25% of issuance at the peak of the last credit cycle in 2007 (according to Standard & Poor’s), I’d say there’s more than some evidence.

I could go on and on here with examples of froth, but you get the point. Jeff Gundlach had this to say in a July interview with Barry Ritholtz: “junk bonds have really gone to levels which under our analysis are pretty much the most overvalued in history.” In late July, highly regarded junk bond investor Martin Fridson said the high yield bond market has been “extremely overvalued for a record nine consecutive months.” Fridson went on to say that the “pressure to find yield is causing investors to rationalize investing in paper that is subject to major price risk.”

Give Me Yield or Give Me Death

After five and a half years of holding rates at 0%, to suggest that the Fed has nothing to do with this reach for yield behavior is beyond nonsensical. Investors have grown more than tired of waiting for the Fed to stop artificially depressing yields. They are absolutely desperate. Anyone who has spoken with investors or advisors in 2014 understands this is the number one issue on everyone’s mind. Investors want their yield, the more the better, and are no longer concerned with any of the risks associated with reaching for that yield.

We’re hearing stories everyday about the lengths investors are going to in their desperate reach for yield, and none of these stories are good. One of the most unfortunate has been the proliferation of high yielding non-traded REITs, which Josh Brown of Ritholtz Wealth calls “murderholes” and FINRA has issued warnings on (click here). If you’ve never heard of these products, consider yourself lucky. The fact that brokers are in love with these products (highest commissions) should tell you everything you need to know about them.

As FINRA explains, “during extended period of low interest rates, investors often seek products offering more attractive yields.” Indeed they do, but most investors fail to understand that those “more attractive yields” do not come without a cost: higher risk.

Retirees have become particularly desperate, many of whom have to choose between reaching for yield or returning to/remaining in the workforce to maintain their standard of living. As we know, many have chosen to work longer, and this has only exacerbated the problem of unemployment in younger workers.

The point here is that there is no free lunch, as much as the Fed wants us to believe that there is. There are many real costs to keeping interest rates this low for this long, and we haven’t seen the half of it yet.

When Reaching For Yield Goes Wrong

“But with low interest rates and abundant availability of credit in the nondepository market, the bond markets and other trading markets have spawned an abundance of speculative activity. There is no greater gift to a financial market operator—or anyone, for that matter—than free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call ‘beer goggles.’” – Richard Fisher, Dallas Fed, July 16, 2014

In a recent speech, Dallas Fed President Richard Fisher highlighted the many risks of continuing with zero-interest rate policy after so many years. I would encourage you all to read the entire speech, but the quote above was particularly important for investors, as he notes that zero-interest rate policy “enhances the appeal of things that might not otherwise look so comely.”

The best example I can think of in this regard is a high yielding fund in closed-end universe: The Pimco High Income Fund (PHK). I wrote about the Fund a few months back as an example of how the market is anything but efficient as investors are so hungry for yield that they were willing to pay a 50+% premium for a product that promises a high yield in return. Back then the Pimco Fund was trading at over a 53%premium to its net asset value (NAV) and was sporting an NAV distribution yield of 17.7%.

As I wrote back then:

“If you’re wondering how the fund manages to pay out such a lofty distribution while yields on almost every class of bonds are near all-time lows, you’re not alone. I was asking the same question the first time I came across the fund. After doing some digging, we find that the average coupon of bonds in the PHK portfolio is only 6.8%, and the 17.7% distribution is achieved through a combination of leverage, derivatives, and a return of capital.

The average retail investor, of course, neither has the capacity nor the desire to understand these intricacies. They see a 17% “yield” and Bill Gross as the fund manager and cannot buy PHK fast enough. As the old saying goes, a “fool and his money are soon departed.”

In the past week, we started to see just how quickly this can go wrong for investors. The Fund has declined 11% over that time but still trades at over a 40% premium to its NAV.

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Now I will accept some amount of caveat emptor here, but what I won’t accept is that the Fed should not be held responsible in the years to come for the significant sums of money that will have been lost by investors that were essentially forced into risky assets at this late stage of the game.

And make no mistake about it, it hasn’t even started yet. We are not even in the first inning; we’re still in the pregame warmups. The decline in PHK is merely a precursor of what’s to come. As I wrote recently in the Fed Prisoner’s Dilemma, the big money has already started moving out of riskier asset classes this year in anticipation of the end of QE in October and higher rates next year. In the risky credit markets, we only started seeing significant outflows start in mid-July.

What Is The End Game?

The end game for investors reaching for yield here is clear: eventual disappointment and pain. But what I have been thinking more about lately is what exactly is the end game for the Fed? As much as I poke fun at the institution and its voting members, these are highly intelligent people. They can clearly see that we are more than five years into the recovery, jobless claims are at an 8-year low and payrolls have advanced by more than 200,000 in each of the past six months. And yet, they continue to say it “will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.”

Therefore, the only conclusion I can come to is that they actually want another bubble to occur. After all, how could we rationally conclude otherwise? Before this period, the longest stretch of time the Federal Reserve had held interest rates at a trough level after a recession was one year, from June 2003 to June 2004. As we know, this was one of the proximate causes of greatest housing bubble the world has ever seen. We are at five and a half years now and we’re supposed to believe that the Fed is not expecting a similar or greater bubble to be formed?

But why would the Fed want another bubble, you ask? I don’t know but I certainly wish this question would be asked of Ms. Yellen at the next press conference. If I were to speculate, though, I would say that they (1) believe in their hearts that they are the only game in town (meaning there is not enough end demand and the economy cannot support itself on its own), (2) are true believers in the “wealth effect” policy initiated by Bernanke in 2010 (click here), or (3) are acting as a political body keeping interest rates low, which is the only way America as a country and us individually can keep taking on more debt and spending money we don’t have.

The Fed Ponzi Scheme and the Third Bubble in Fifteen Years

While seemingly innocuous, the problem with these beliefs is twofold. First, they ignore any deleterious long-term effects of their policies. Second, they are all predicated on keeping the Ponzi scheme of easy money going. For if we are to believe that there is only good and no bad that comes from 0% interest rates, then it would stand to reason that any reversal of this utopian policy would be very bad indeed. As Stan Druckenmiller has said: “the wealth effect they’ve been using to prop this thing up, once that’s removed, you go down on no volume, you reprice. I will bet from beginning to the exit the wealth effect of QE will have been negative, not positive. Negative.”

The traders out there will respond to all of this and say who cares if there is repricing at some point in the future that wipes out much of the supposed wealth effect. Carpe Diem. The trend is your friend. Let’s simply enjoy the gains now and keep dancing until the music stops.

That’s fine if you are a nimble trader, but most investors are not and regardless, my commentary here is not about where the S&P 500 is going to be at the end of the month. This is about longer term policy and whether the risks of keeping interest rates low for this long outweigh the short-term rewards of higher stock prices. In 2008, 2009, and perhaps even 2010 one could make the case that the risks were outweighed by rewards. But today, it is an entirely different ballgame. We’re far past the point where easing is helping the economy and I would argue it is actually a headwind here as it 1) is a tax on savings and therefore investing, 2) is leading to a gross misallocation of resources, 3) is putting less money into the hands of consumers, 4) is not helping real wages as asset price and commodity inflation outpace income gains, and 5) has only widened the wealth gap.

Additionally, I would remind traders repeating the “don’t fight the Fed” mantra that a continued rally without correction due to 0% policy is not an inalienable right. Don’t mistake correlation and causation. You don’t have to go back very far to see sharp declines for the S&P 500 in 2010 (-17%) and 2011 (-21%) when zero-interest rate policy was firmly in place. You also don’t have to go back very far (this year) to see the average stock down through seven months (click here) in spite of 0% interest rates.

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And I know it is a forgotten memory at this point, but try to recall that the S&P 500 declined 51% from 2000 to 2002 and 57% from 2007 to 2009 while the Fed was cutting rates the entire time (from 6.5% in 2000 to 1.25% in 2002; from 5.25% in 2007 to 0% in 2009). Sometimes “fighting the Fed” or at least not drinking the cool-aid is the most rational decision for investors.

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My conclusion here is as follows. Keeping interest rates too low for too long in the late 1990’s enhanced the internet bubble. Keeping interest rates low for too long in the early to mid-2000’s greatly influenced the housing bubble. After five and a half years of 0% interest rates, the Federal Reserve has already created the third financial bubble in less than fifteen years. Make no mistake about it: we are in the midst of the greatest reach for yield bubble that we have ever seen. And with the Fed still saying that they are going to keep interest rates at 0% for an “extended period” of time, we can only assume that they want the “reach for yield” bubble to continue and grow even larger.

Do I know exactly when it will burst? No, of course not, nobody does. But should we sit here fiddling with the assumption that it will end any better than the prior two bubbles?

Market participants are likely to keep dancing for as long as they can, as they still expect the Fed to keep rates at 0% until next July (see chart below). But the dance floor is getting awfully crowded here as we move closer to that date. How certain are you that you’ll be one of the first ones off? What are the odds that the Fed-induced reach for yield doesn’t go wrong?

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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