The Behaviorist: Junk Bond Déjà Vu

October 14, 2010

Ultra-low yields can and will cause investors to make mistakes. It’s human nature.

Desperate times create desperate investors. Not long ago—to paraphrase Will Rogers—investors were far more concerned about the return of their principal rather than the return on their principal. Times have changed.

Kent GrealishDespite reports of a weakening economic growth, high-yield bonds (“junk bonds”) are having a field day. In the first nine months of 2010, junk bond sales have already exceeded the record set in 2009 by more than 25 percent.

High-yield bonds issued three or four years ago would normally be contributing to higher default rates about now. But below-investment-grade companies, which might have been expected to experience difficulty rolling over debt in such a weak economic recovery, have been able to refinance and even extend their obligations at favorable terms. A yield-hungry market has postponed the inevitable and reinforced investor complacency. For this, we can thank the Federal Reserve.

It seems like nothing causes an investor to lose his inhibitions about credit risk more than lower interest rates. With “safe” investments paying next to nothing, the fixation on getting a higher rate of return has created a kind of desperation among otherwise risk-conscious investors. The Fed’s zero-interest-rate policy has produced real agony for fixed-income investors and, in reaction, they are suspending concerns about getting their money back. This is a recurring theme in human behavior.

My first experience with it came in the early 1980s when the Fed under Paul Volcker began to get inflation under control. As yields fell, investors who had learned to stay in short-term obligations while inflation pushed interest rates higher now found they had to roll over their T-bills and notes at lower rates. Attitudes began to change.

I remember one woman in particular who complained that she could no longer get 10 percent on her 90-day Treasury bills. The fact that her T-bills were absolutely safe no longer seemed so important. She told me that she needed a 10 percent return and since T-bills could no longer provide it she wanted something else. Along with many other investors, she decided that maintaining historically high yields had now become more important than safety.

Initially many investors shifted to government national mortgage association (GNMA) obligations, seduced by the idea that GNMAs were guaranteed by the government. Scores of “government” mutual funds were created to meet the growing demand. A few years later, these same investors were surprised to find that they could lose money on GNMAs, as their fund’s high-interest mortgages were refinanced and the large premiums paid for high-coupon pass-throughs disappeared.

Junk bond mutual funds, a new phenomenon at the time, also became popular. Demand was so high that the brokerage firm I worked for brought out five different high-yield bond funds. I’m proud to say that I didn’t recommend any of them. Nevertheless, there was no shortage of buyers. When the savings and loan crisis came along in the late 1980s and sank the junk bond market, my firm’s “flagship” fund dropped 40 percent as creditworthiness finally regained dominance over yield.

Today’s obsession with yield will also turn out badly. Human nature makes it a question of when, not if.

Kent Grealish is a financial adviser with San Bruno, Calif.-based Quacera Capital Management LLC. Grealish, an accredited investment fiduciary® (AIF®) and a certified financial plannerTM (CFP®), provides services on an hourly, fee-only basis.


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