As interest rates continue to decline, we increasingly receive
questions about how we can obtain a greater yield on portfolio
assets. As I have frequently said, we can always obtain more yield
if we simply accept more risk, either in the credit quality of the
assets we hold or in the maturity of those assets.
For more than a decade we have been warning about elevated risks
in the economy because of excessive debt levels. Over that same
period we have warned about equity risk stemming from historically
extreme valuations, excess leverage and the secular weak cycle that
the markets entered just after the turn of the century. Those that
seek yield from high dividend-paying stocks bear an inordinate risk
that such yields will compensate only partially for principal
losses in a declining stock market environment.
Bonds have been the traditional vehicle to provide portfolio
yield. While we made some profitable forays into the Treasury
market in recent years, our clients would have been better served
had we simply ignored interest rate risk and held Treasuries
throughout the past decade. With the 10-year note yield now around
2.5%, profit potential has been substantially reduced, and an
increase in yield could quickly produce bond market losses. Moves
in corporate and municipal bonds have been far more volatile. As
the economy contracted in 2008, prices of corporates and munis fell
hard with fear growing about the survival of our financial system.
The Federal Reserve's efforts to shore up the system boosted
investor confidence, however, and corporates and munis rocketed
upward in price. That rally continues today. Willingness to accept
risk was rewarded. In fact, the more risk accepted, the greater the
reward. The riskiest of junk bonds, CCC-rated, returned over 100%
in the first twelve months of their rally off the financial crisis
The continuation of the bond rally becomes increasingly
problematic the lower rates fall. Economic conditions are weakening
again, and the Fed has indicated its intention to hold short rates
near zero for the foreseeable future. In fact, the softness in the
economy is increasing the prospect that the Fed will serve up
another large dose of quantitative easing, already being referred
to as QEII. There is political opposition to further bailouts, but
analysts are leaning toward the belief that the Fed will once again
act by their September meeting. They could undertake another
program of purchasing more Treasury notes and bonds, despite their
already very low yields. All else equal, that would sustain the
bull market in Treasury paper. All else, however, is not always
equal. China is the largest foreign holder of our Treasury
securities. They have cut back their holdings over the past two
months. Others have stepped up to replace the Chinese, but that
could change fast. At current low yield levels, it would take only
a minor rise in yields to turn a full year's total return negative.
Should yields rise simply to where they were just over one year
ago, losses would be significant. At these yield levels, the risk
from a rise in yields is substantially greater than the potential
reward from a further decline in yields.
Regardless of what happens to Treasury yields, there is far more
significant risk in corporate and municipal bonds. Rising rates
would hurt all bond prices. While falling Treasury rates would
benefit Treasury bond prices, the reasons for those falling
rates--weak economic conditions with or without deflation--could do
a great deal of damage to corporate or muni bond prices. We do not
want to take that risk.
For money not invested in stocks or bonds, we have over the
years made generous use of laddered certificates of deposit to
boost portfolio yield. The Fed's actions to reduce short rates
virtually to zero removed most of the attractiveness of that
alternative. Compounding that rate reduction is the decrease in
demand for borrowed funds by banks that formerly issued large
volumes of CDs. We continue to put some money in one and two-month
CDs, but we have been reluctant to extend maturities beyond that at
the minimal yields available.
Clients ask why we do not buy longer CDs at higher yields. We
constantly weigh that alternative. Evaluating our expectation for
possible changes in rates, we set minimum yield levels for various
maturities. Currently we would not tie money up for three months
for less than 1% or for a year for less than 2%. The full year rate
is not available today and the three month rate only available in
the rare instance in which a bank badly needs short-term funds.
To tie funds up for a very small return is to lose the option to
use that money more productively in a stock or bond transaction
which could arise very quickly in an environment of great economic
and market uncertainty and volatility. For example, just over a
year ago we deployed a significant portion of client portfolios
into 10-year U.S. treasury bonds when yields spiked up to 4%.
Although we took profits on that position just a month later, the
boost that it gave the full year return was far more than could
have been earned with the same money in a CD for the entire year.
While we can never be sure that we will find such strategic
opportunities, they have occurred with sufficient frequency over
the years that we are unwilling to forego such options unless we
are being rewarded adequately to do it. Right now we are clearly
not being paid much to tie up funds, so we are keeping most of them
We are working doubly hard, however, to locate options to earn
even small amounts of safe additional yield. Our recently opened
program bank operation is a case in point. This program enables us
to increase the yield on money that is effectively liquid and FDIC
guaranteed, while earning higher returns than are available in safe
money market funds.
We are also exploring the possibility of buying longer CDs from
the few banks that would allow us to cash in CDs early without the
typical penalty. Such an alternative would get us somewhat better
returns while enabling us to retain the needed liquidity.
Unfortunately, those opportunities are difficult to find.
The 'Deleveraging' Deception