More money has been lost reaching for yield than at the point of a gun—Raymond Devoe
According to a recent article in the Wall Street Journal, desperate investors are reaching for yield, this time in the high-yield bond market. The less-polite name for these securities is junk bonds. Why do investors love them so? Well, they pay out fat yields—but, of course, they come with commensurate risks. And there are already warning signs in the market.
So much money has flooded into the junk-bond market from yield-hungry investors that weaker and weaker companies are able to sell bonds [they say]. Credit ratings of many borrowers are lower and debt levels are higher, making defaults more likely. And with yields near record lows, they add, investors aren’t being compensated for that risk.
Also worrying money managers is that some new sales have similar hallmarks to those that preceded the financial crisis in 2008. Petco Animal Supplies Inc. and Emergency Medical Services Corp. recently offered to sell bonds that let them pay interest in the form of more bonds, instead of cash, a common provision before the crisis.
Skeptics note that now weaker companies are the ones borrowing. The portion of new bonds sold by high-yield companies with credit ratings of double-B and above shrank last month to 20% from an average of 30% for the year.
After three years of financial improvement, high-yield companies are now weakening by some measures. Total debt for all high-yield companies rose 7.2% in the 12 months through June—the largest rise since 2008—while cash on their balance sheet fell 2.3%, according to research by Morgan Stanley. S&P downgraded 45% more companies than it upgraded in 2012, reversing the trend of 2010 and 2011. And companies are offering investors fewer protections than usual.
Now, this is just supply and demand at work. Investors want yield and companies are happy to oblige them, especially if they are willing to buy really junky securities.
The problem is that, from time to time, investors forget that investing is about total return, not just yield. An 8% yield with a 20% capital loss still puts you in the hole. Likewise, buying a stock that appreciates 20% but that does not pay a dividend still puts you way ahead of the game. When you go to the store to buy groceries, the store owner does not care if the money comes from labor, dividends, interest, or capital gains.
Money is money, however you make it. You’re probably better off—and safer—with a healthy total return from a well-diversified portfolio than you are reaching for yield.
