Update On Yield Chasing -- Genghis Bond Edition

Includes: TIP
by: Roger Nusbaum

Last week I mentioned a bond offering for Mongolian sovereign debt (so called Genghis bonds) that was priced very low (yield-wise) but that was very much oversubscribed. In that post I mentioned that the long term prospects for Mongolia are good because of the vast resources in the ground but that the government has done a few things here and there that could impede progress to fruition.

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The FT posted the above chart and an account of trouble brewing in the country's coalition government and the bonds got hit because of it.

This is an usual example of the consequence for chasing yield because of how quickly there was a problem but the arc is very common even if time compressed. The move in the bonds is obviously not a death blow but there was volume at the top of that chart and for now there is plenty of uncertainty, apparently more so than when these bonds were issued a few days ago.

The big point is not that no one should reach for yield but a lot of people reach for yield and don't realize they are doing so which often leads to a painful realization later. What I think causes this is not enough understanding among market participants that a 7% yield in a zero percent world takes on a lot of risk. On a more nuanced level realizing that 5% is not enough compensation for lending money to Mongolia would come next in the learning process.

In constructing your portfolio it is important to understand the risk and volatility profiles of each holding. Most client accounts own the TIP ETF and also own a preferred stock or two. The following chart has TIP in blue and a preferred stock (symbol erased) in red.

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The preferred stock is obviously alive and well but it got crushed during the financial crisis. If capital markets ever stop functioning for a time like they did in 2008 then I would expect most preferred stocks to again get crushed. The case of this one stock was not a permanent impairment of capital but if too much of the portfolio is in things that can go down that much then the overall drawdown could be panic inducing which could lead to panic selling.

Unrelated, as Paul Sherwen would say; Tim Geithner really threw a cat among the pigeons with that interview yesterday. They'd "absolutely" let the economy go over the cliff? Is there anyway that is what he really meant to say?

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