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 lows.
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 liquid.
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.
Disclosure: No positions