Don’t be a yield pig. (seeking high current rates in investments)
Seth A. Klarman
Brief
Summary: Some investors seek high yields with no thought of the risk.
In today’s stock market situation, it is better to use up some acquired
capital funds than to risk major loss.
I HAVE
THOROUGHLY reviewed the U.S. Constitution (and the Bill of Rights for
good measure) and, contrary to popular belief, there is no mention of a
right for savers to earn high rates of interest on government-guaranteed
principal. Nevertheless, it comes as a terrible shock to a lot of
people that some current short-term interest rates are only one-third of
early 1980s levels. The correct response to this shock can be crucial
to your financial health.
There is always a
tension in the financial markets between greed and fear. During the
1980s investor greed frequently got the better of fear, with the result
that yield-seeking investors, known among Wall Streeters as “yield
pigs,” were susceptible to any investment product that promised a high
current rate of return, the associated risk notwithstanding. Naturally,
Wall Street responded by introducing a variety of new instruments–junk
bonds, option-income mutual funds, international money market funds,
preferred equity return certificates (PERCS)–anything that promised
high current yields to investors.
Unless they
are deluding themselves, investors understand that to achieve
incremental yield above that available from U.S. government securities
(the “risk-free” rate), they must incur increasing levels of principal
risk. There is no risk-free yield enhancement on Wall Street. The
painful result: Higher risk investments often erose one’s capital and
produce lower returns–the worst of al investment worlds.
Higher-returns-for-higher risks only applies on average and over time.
Investors
must carefully examine alternative investments to assess when they are
being adequately compensated for bearing risk and when they are not.
When the yield differential between riskless and more risky securities
is sufficiently large, ven a conservative investor might reasonably
venture beyond U.S. government securities. Thus, for example, it made
sense to buy the Federated Department Stores senior secured bonds,
Harcourt Brace debentures and Manville preferred stock when panic hit
the junk bond market in late 1990 and early 1991.
These
days, however, I don’t believe investors are being compensated
sufficiently to venture beyond risk-free instruments. Yield spreads
between government bonds and corporate credits have contracted sharply
this year from levels a year ago. Some bonds of such highly leveraged
issuers are Burlington Industries and Unisys now trade above par. A year
ago the sold at substantial discounts from par.
Yield-starved
investors also have been bidding up the bonds of such deeply troubled
issuers as Chrysler, Stone Container and Marriott. The General Motors
PERCS–a newly created instrument that only a yield pig could
love–recently traded at a level so high that the common stock became a
better buy no matter where GM common traded and no matter what action
GM’s board took on its dividend.
Some
investors, desperate for better yield, have been reaching not for a new
Wall Street product but for a very old one–common stocks. Finding the
yield on cash unacceptably low, people who have invested conservatively
for years are beginning to throw money into stocks, despite the obvious
high valuation of the market, its historically low dividend yield and
the serious economic downturn currently under way.
How
many times have we heard in recent months that stocks have always
outperformed bonds in the long run? Funny, but we never hear that
argument at market bottoms.
In my view, it is
only a matter of time before today’s yield pigs are led to the
slaughterhouse. The shares of good companeis and bad companies alike are
vulnerable to sharp declines. Moreover, many junk bonds that have
rallied will tumble again, and a number of today’s investment-grade
issues will be downgraded to junk status if the economy doesn’t begin to
recover soon.
What if you depend on a higher
return on your money and can’t live on the income from 4% interest
rates? In that case, I would advise people to ignore conventional wisdom
and consumer some principal for a while, if necessary, rather than to
reach for yield and incur the risk of major capital loss.
Stick
to short-term U.S. government securities, federally insured bank CDs,
or money market funds that hold only U.S. government securities. Better
to end the year with 98% of your principal intact than to risk your
capital rooting around for incremental yield that is simply not
attainable.
I would also counsel conservative
income-oriented investors to get out of most stocks and bonds now, while
the getting is good. Caution has not been a profitable investment
tactic for a long time now. I strongly believe it is about to make a
comeback.
