The Chasing-Higher-Yields Risk

In a recent article, an annuity market specialist was warning insurance company purchasers to hurry up and lock in yields now since they had peeked a month ago and are heading down.

Really? No one has a crystal ball about the directions of prices. It wasn’t too long ago that a barrel of crude oil was $115. Yesterday it was at $87. As I write, it’s around $90. What will the price be a month from now?

Here’s a quote from CNBC regarding an analysis done by Deutsche Bank’s chief international economist back in 2017: “Wall Street economists and strategists are tasked with telling the future. Predictions are often based on historical research and analysis…but according to…forecasts for one of the economy’s benchmark measurements, the rate on the 10-year Treasury note have been ‘consistently wrong’ and too optimistic for the last decade and a half.”

That’s why executing a bond ladder strategy makes sense. That is, building a portfolio of individual bonds that mature on different dates, which can provide current income while minimizing exposure to interest rate fluctuations.

Instead of buying bonds scheduled to mature in the same year, by spreading out the maturity dates, investors are freed from trying to time the market. And if the so-called experts miss on their predictions so often, why should anyone take such a risk?

Two issues must be handled, however:

·      How far out should the maturity dates go?

·      How financially strong should the companies be?

To the first question, five years is almost always long enough. Recent yields were:

1-year Treasury           3.26%

 5-year Treasury:        2.97%

10-year Treasury:       2.82%

30-year Treasury:       3.10%

Notice that the yield curve has been inverted lately; higher yields are available for shorter time periods. Inverted yield curves are often an accurate predictor of recessions.

So a fixed income portfolio could be divided as follows:

·      20% in corporate bonds maturing in 1 year

·      20% in corporate bonds maturing in 2 years

·      20% in corporate bonds maturing in 3 years

·      20% in corporate bonds maturing in 4 years

·      20% in corporate bonds maturing in 5 years

And as the 1-year bonds mature, they are then replaced with 5-year bonds.

To the second question regarding quality, only buy the best of the best corporates with the goal of getting an extra 100 basis points or so. For instance, Microsoft, with over $130 billion of cash on its balance sheet in 2021, has a bond maturing in February 2027 with a coupon of 3.3%. Not great, but worth comparison shopping against other financially powerhouses. But Apple, with $200 billion of cash on its balance sheet, is offering a 40-year bond projected to be 150 basis points or 4.60%. No way. 40 years is like an eternity, as companies like Polaroid and Kodak used have cutting edge technologies.

“High-quality bonds tend to be very, very good performers in recessionary environments, in part because recessionary environments typically spur a flight to quality, and high-quality bonds are one of the key high-quality investments that investors look to — but also because interest rates often decline in recessionary periods, which makes high-quality bonds worth more. It elevates high-quality bond prices,” says Morningstar’s Christine Benz. “Investors might be inclined to throw bonds overboard given how poor their performance has been in the first half of 2022 (but) they tend to be good ballast for equities in some sort of an economic weakness or recessionary environment.”

(Treasury Inflation-Protected Security (TIPS), or Treasury bonds indexed to an inflationary gauge and Series I Savings Bonds are also good ways to protect fixed assets from a decline in purchasing power.)

As the Wall Street Journal’s Andy Kessler advises, it’s important to keep the emotions under control: “Bernie Madoff promised an 11% average annual return and faked brokerage statements before he made off with investors’ money. You can almost hear the cocktail-party conversations in New York and Palm Beach: ‘You’d be stupid not to do this.’”

Kessler recalls the heady days just before financial meltdown in 2007: “CEO Chuck Prince told the Financial Times, ‘As long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ His job was to assess risk, and he didn’t do it. Citigroup should have sat out the next 18 months. When you buy high-yield debt, junk bonds with ratings of BB+ and lower, there is a default risk, though it’s rarely noted. The best junk bonds today pay 6%. In January it was 4%. In November 2008, as Lehman Brothers and others were imploding, it was 16%. Higher yields imply higher risk. A recession (yes, we’re in one) accelerates defaults… Study the fundamentals, assess future risk, and never fall for the siren call of high yields, especially “guaranteed” returns you’d be stupid not to take.”

I think the old adage, “gentlemen prefer bonds,” is less about the return on capital and more about the return of capital…