How Reaching for Yield Ends

After six and a half years at 0%, savers and investors are beyond tired of waiting for the Federal Reserve to raise interest rates. They are desperate and reaching for yield wherever they can find it.


Last June, Janet Yellen famously noted that there was “some evidence of reach for yield behavior.” Indeed, just as there is some evidence of snow during a snowstorm. Dr. Yellen has since gone silent on the subject as we all know the proximate cause of this desperate reach has been the Fed’s unwillingness to let go of Mr. Zero.

The reach for yield has taken many forms, from investors buying longer-term bonds to riskier bonds to high yielding equities. Unfortunately, none of these are good options for investors seeking safety in yield and all require a higher risk tolerance than most investors appreciate.

Take, for example, the Senior Loan ETF (BKLN). This is a portfolio of leveraged loans with an average credit rating of BB. With all-time low yields last year and deteriorating credit standards, investors certainly had little appreciation of what they were buying. They just knew they needed more than 0%, and Senior Loans were one way to reach for a higher yield.

The result? A year later, Senior Loans are marginally lower. Not terrible, you say. At least they had the chance of a higher yield. Perhaps, but investors would have been better off in a high yield savings account earning 1%, which is truly risk-free. In buying senior loans they were hoping for a risk-free higher return and what they received was return-free risk.


Similarly, in Junk or High Yield bonds (HYG), investors have been accepting a high level of risk over the past year in exchange for a negative total return.


These are of course benign outcomes in the midst of an economic expansion and overall bull market. What happens when the cycle turns? In 2008, leveraged loans and high yield bonds declined over 30%. How many investors buying these instruments today are willing to accept anything close to a 30% drawdown?

A more egregious example has been the Pimco High Income Fund (PHK). I started writing about this closed-end fund last April when it was trading at over a 53% premium to its net asset value (NAV). You read that correctly. Investors were so enthralled by the yield-to-NAV of 17.7% they were willing to pay $1.53 for a $1.00 of assets. Fast forward to today and the Fund is down over 14% in the past year, but still trading at a 35% premium to NAV.


What is the End Game?

The end game for investors reaching for yield here: eventual disappointment and pain. You simply cannot change your risk tolerance and there is no free lunch. Higher yield means higher risk even if that risk isn’t evident at first blush.

Investors today may believe they can handle this risk but once it starts moving down reality sets in. They often sell in a panic, realizing a permanent loss, just as we saw in the last cycle.

The longer the Fed waits to raise rates, the more desperate investors will become. Don’t fall prey to this urge to reach; stick with an investment plan that is aligned with your risk tolerance. The Fed does not “have your back” as the saying goes. Far from it. They will accept no responsibility for building this house of cards when it comes crashing down.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.


Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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