High Yield Crack Yo!

Posted on Nov 17 2014 - 11:44pm by Sharpe Trade

As we begin a discussion of my thoughts of many “high yield” instruments in popular use, let me say that we could start this off as a discussion of non-Gaussian distributions during economic events, and the increasing tail risk during such events as non-linear distributions.  That it would be a mistake to think in very linear terms as we approach the end of ZIRP …

Copula

However, I fear the folks we here at Sharpe Trade would like to reach out to, would understand such a discussion.  But it would be as exciting as watching paint dry

So let’s make this as simple as possible.  At the same time, we hope people that are brand new to the markets, a completely new discretionary self-directed retail trader who opened their account last week, will be able to follow along.  And we can begin with a bit of a history lesson of what has occured.

For nearly six years …. we have had a Fed Funds rate at effectively, 0%

Simply put, this means that any cash you have in the States, be it in your brokerage account, or at your bank, you’re getting paid in terms of yield on that money.  As well as getting paid very little on instruments like money market accounts (do those even still exist? lol) or Bank CD ladders … there has been very little interest paid.  Very little in the way of fixed, safe, income.  Because it all, in essence, starts with the Fed Funds rate, which right now, is as we’ve said, at zero.  Now … something that many new folks fail to consider or remember is something that we would only be too happy to remind you of …

You need income.

Both of us have talked for years, that investors need income and as a separate income account.

Wealthy people need income because yes, believe it or not, it’s not wise to live off a stack of cash as if you were a dwarf with a pile of Gold.  Wealthy people and institutions have bills they need to pay each month.

A trading account, and investing account, is not strictly for income.

Investors and traders … need income.

A trading account, and a portfolio, is to build up a stack of cash.  Yes, it may contain a few pieces which are income related as a part of that account.  But it’s purpose is not that of receiving fixed income.  A fixed-income account is to pay you each and every month, so that you can pay the bills.

Now this has been a problem during this six year period of ZIRP (Zero Interest Rate Policy).  For decades, one could simply have some of this cash, well … in cash and cash instruments.  You’d be paid nicely.  You could buy bonds, and rotate them, and you’d be paid a nice monthly interest payment on that bond.

However, with the enactment of ZIRP to stabilize the economy, these interest payments have been dropping.  Less and less stable income for individuals, for trust funds, for pensions in the form of stable bond and bond yield.

However, this did not negate the need for income.

You need income.

Wealthy people need income.

A trading account, and investing account, is not strictly for income.

Investors and traders … need income.

So as time passed, we could say that money began to seek higher yield.

And thus the game began.

The search began for higher yield instruments.  Junk Bonds and lower quality credit instruments.  MLP’s.  REIT’s.  Land trusts.  Emerging Market yield. All good instruments on an individual basis as long as an investor has done their due diligence and understands the risks involved with such instruments and how they can be used with proper thoughts towards risk management.

ZIRP has lasted much longer than people thought.  And thus a large amount of money has flowed to lower quality credit items.

That’s the history lesson.  It also spells out an economic event.

What are we saying here?  Have we lost the folks who are brand new to the markets?

Let’s just say that you have two institutions that will pay you money.

Institution A will pay you a little bit of money, but the risk of default is absolutely near zero.  The money you lend them is much safer, and you’re going to get the money back.  But the payments are less (instruments based off of the Fed Funds rate)

Institution B will pay you much more money, but the risk of default is greater.  There is actually a chance that you will not get your money back.  But the monthly payments are greater.

Since everyone has been getting nill from institution A for six years, everyone has taken their money to Institution B.  Over time, this need for yield and a rush to Institution B has become somewhat more of a mad rush.  We have both watched folks simply follow the carrot that had the words “High Yield” attached to it, with little thought to the risks involved.  This rush for yield has become nearly an addiction in some quarters.  This addiction has lasted for some time.  I would say that to even mention the words higher yield income in some circles, has been somewhat similar to throwing crack at a drug addict.

If you follow smart folks in the Bond markets, the discussion for the last year, has been what occurs when Institution A (U.S. Government Bonds) start paying you more money when the Fed Funds rate increases.  Institution A has a default risk of nearly zero.

Everyone rushes for the exit of Institution B, and rushes the door for Institution A.

This is the economic event many smart folks have been discussing for a year now.

It’s an economic event I have kept my eye out for.  The rush of money, exiting higher yield instruments.

I am watching lower quality credit items, and the momentum on yield looking for momentum causing a spike in such yield.  I do expect such instruments to get hit even more than they have been getting hit.  In fact, I can predict nothing, but I would not be surprised if we see such another plunge in higher yield items in the next few days.

And as I was telling some other traders recently, that as we go through such events that unforeseen outliers (if you wish to think of them of Black Swans), and that this can give rise to completely unpredictable results.  As far as looking for sectors for Fixed Income?

Equity plays for fixed income was the place to be a year and a half ago.

If you have income positions that are exposed to lower quality credit items?  I think it might be a good idea to check your yield on cost.  

Disclosure:  I do maintain positions in select higher yield Fixed Income instruments, long, at this time in every portfolio that I manage.  No businesses that I am associated with, to my knowledge, has any position in select higher yield Fixed Income instruments, long or short, at this time.  I am not looking to establish new positions in select higher yield Fixed Income instruments in any direction within the next 24 hours. 

 

2 Comments so far. Feel free to join this conversation.

  1. Sheldon November 18, 2014 at 3:31 pm - Reply

    Hi Dan, Good article well written.

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