Monday, September 21, 2015
There's an old saying on Wall Street that could save you hundreds of thousands of dollars.
"More money has been lost reaching for yield than at the barrel of a gun."
You might not get it at first... But in today's essay, we'll show why it could be some of the most valuable advice you'll hear all year.
We'll start with a reminder of why folks feel the need to "reach for yield." It has to do with the Federal Reserve's low interest rate policy...
The problem with easy money is that it's awful for savers. When banks can borrow money for next to nothing from the Fed, they're certainly not going to pay you, as a depositor, a high interest rate. So a near-0% federal funds rate means savings accounts pay next to nothing, too.
But savers and investors often need income from their savings to live. So low returns in savings accounts (and other low-risk assets) lead folks to put their money into riskier assets, like stocks. They'll also pile money into bonds that have higher yields, even when the risk of default is higher.
As you may have figured out, when investors "reach for yield," they take on more risk in order to earn more income. Today, lots of people are turning to the high-yield bond market to meet their income needs...
High-yield bonds are interest-bearing loans issued by companies with weak financial positions. Because the risk of these companies not paying you back is relatively high, these bonds – often called "junk bonds" – pay higher interest rates than the bonds of financially strong companies.
Usually, weak companies need to pay much higher rates in order to attract capital. But lately, a strange thing has happened. Rates aren't much higher than safer income vehicles... Yet investors are still piling in.
One of the easiest ways for investors to buy junk bonds is through the iShares iBoxx High Yield Corporate Bond Fund (HYG). HYG is an exchange-traded fund (ETF). This means it buys and sells assets, and creates and liquidates shares, along with demand. When investors are interested – and they're buying more than they're selling – the share count rises. When they lose interest, the share count drops.
In the chart below, you can see that HYG's share count (the black line) has risen tremendously over the last eight years... But its yield (the blue line) has continued to fall. Today, HYG yields just 5.4%.
To get some perspective on the quality of bonds HYG holds, here's Standard & Poor's definition of the highest-quality junk bonds:
Only 56% of HYG's bond holdings are rated that highly. The other 44% are worse.
Now, consider that 10-year U.S. government bonds yield 2.2%. These are considered among the safest bonds in the world. Given the much greater risk of default with junk bonds, do you really want to reach for an extra 3.2% a year? An extra $320 on a $10,000 investment?
If you buy junk bonds today, it could be one of the worst financial decisions of your life. All it would take is some "adverse conditions" to set off a wave of defaults... and much lower prices for funds like HYG.
If you're still not convinced, we have another chart to show you. It represents a MUCH better opportunity than junk bonds. The bonds are of a much higher quality... And the yield is higher.
We're talking about municipal bonds. We've written a lot about "munis" in past essays... But the short version is, these are loans made to cities and states instead of to companies. They're not all high quality (think Detroit a few years ago)... But many are.
Take the Nuveen Municipal Opportunity Fund (NIO), for example. It holds 394 municipal bonds... and only 4% of its holdings fall under the "junk" classification. Most are highly rated... and much less likely to default. Yet today, NIO has a 6.4% yield. And that yield is tax-free (on the federal level).
If you're in the 28% tax bracket, a 6.4% tax-free yield is equivalent to an 8.9% taxable yield.
The chart below compares the yields of a Bank of America Merrill Lynch junk-bond index (which we used to get a longer history than exists with HYG) to the yield of NIO. This comparison is called a "yield spread." When the spread is positive, junk bonds yield more than NIO. When the spread is negative, NIO has a higher yield.
Over the last 19 years, the average spread was 3.2%. In other words, junk bonds had an average annual yield 3.2 percentage points above NIO. Today, the junk-bond index yields 7.2% (which is more than any junk-bond ETFs we were able to find)... and NIO yields 6.4%. That means the current spread is just 0.8%.
We likely wouldn't even think about buying junk bonds as a group until the spread reaches 6%.
Why would you? Greater risk... lower tax-equivalent yields.
If you're looking for income today, don't reach for extra risk. Buy municipal bonds instead.
Brian Hunt and Ben Morris
One of David Eifrig's favorite bond investments over the past few years has been closed-end municipal bond funds. "If you switch some of your capital into muni bonds, the income they generate will flow to you, tax-free," he writes. "And with municipal-bond funds, you can get a diversified collection of the top-rated bonds in just a few minutes." Get the full story here.
Brian and Ben say municipal bonds can help you build a diverse, disaster-proof portfolio. "Don't make the insane mistake of betting your retirement all on the stock market," they write. Learn more right here.
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