To help prevent the next Great Depression, in 2008, the Federal Reserve increased the “price” of avoiding risk.
Fearful investors seek the safety of Treasury bonds (as well as government agency bonds and FDIC-insured CDs). When they do so, they forgo the risk premiums available from non-Treasury debt and equity investments. Driving the rates on Treasury bills to virtually zero led many investors who rely on a “cash flow approach” to investing to frantically search for higher yields.
Higher bond yields can be achieved in two ways. The first is to take incremental maturity risk, which would increase the volatility of the portfolio and subject you to increased risk of unexpected inflation. The second is to take incremental credit risk.
Another way to increase yield is in equity investments, such as stocks with a high dividend yield, real estate investment trusts (REITs) and master limited partnerships (MLPs). This route was the one chosen by many.
All three strategies are in conflict with the main role of fixed-income assets in portfolios—to reduce the overall level of portfolio risk to an acceptable level, allowing you to hold the amount of equities that is appropriate given your ability, willingness and need to take risk. Therefore, fixed-income instruments should be limited to only those of the highest investment grade.
Investors Fail To Learn Market Lessons
Spanish philosopher George Santayana famously proclaimed: “Those who do not remember the past are condemned to repeat it.” Unfortunately, far too many investors have short memories, forgetting the lessons the market has repeatedly provided, and as recently as 2008. Investing in risky high-yield assets works until it doesn’t!
It stops working when equity markets fall, exactly when the safety of high-quality bonds is needed most. Investors in such “alternative” fixed-income investments—such as high-yield bonds, convertible bonds, emerging market bonds, preferred stocks, MLPs and stocks with high dividend yields—all suffered large losses in 2008.
A few municipal bond funds even lost more than 40% in 2008, including Oppenheimer’s Rochester High Yield Municipal Fund (ORNAX), which lost 48.9%. Oppenheimer’s Total Return Bond Fund (OPIGX), which investors presumably used as a core bond holding, lost nearly 36%. And that return looks great compared to the loss of more than 78% for Oppenheimer’s High Yield Champion Income Fund (OPCHX).
Stretching For Yield Comes With A Price
Investors who stretched for yield paid a severe price. Following are other examples of the returns to higher-yielding investments in 2008: the Vanguard Real Estate Index Fund ETF (VNQ) lost 37.0%; Vanguard’s Convertible Securities Fund (VCVSX) lost 29.8%; the Vanguard High Dividend Yield Index Fund (VHDYX) lost 32.5%; the JPMorgan Emerging Markets Debt Fund (JEDAX) lost 29.0%; MLPs lost 36.9%%; and the iShares US Preferred Stock ETF (PFF) lost 23.9%.
While all these risky investments were experiencing large losses, Vanguard’s Intermediate-Term Treasury Fund (VFITX) returned 13.3% and Baird’s Quality Intermediate Municipal Bond Fund Class (BMBIX) returned 6.4%. While these high-quality fixed-income assets were helping to dampen the losses created by a portfolio’s equity holdings, the other risky assets were contributing to the problem. In addition, investors in high-quality assets were able to rebalance, selling some of their high-quality bond holdings at higher prices in order to buy riskier assets at lower prices (and then benefited more from their eventual rebound).
Key Lessons From 2008
Investors should learn two lessons from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk—when the risks to equities show up, credit risk tends to rear its ugly head.
Thus, credit risk and equity risk don’t mix well in a portfolio. That is why I recommend limiting fixed-income investments to only Treasuries, government agency debt, FDIC-insured CDs and the highest-investment-grade municipal bonds (AAA/AA that are general obligation or essential service revenue bonds).
A column I wrote in November 2018 provided the evidence to support the recommendation to avoid corporate credit risk because there are superior alternatives (such as certificates of deposit, CDs). However, if you are going to take corporate credit risk, limit it to only high-investment-grade and short-term bonds. Investors who did so avoided the severe losses many experienced in 2008.