The Virtues of Yield

Includes: AGG, HYG, JNK, PGX, TYY
by: Investment Pancake

Treasuries are partying like it is 1999, and basically have been ever since 1999. The secular bull market in Treasuries must end at some point, as all secular bull markets eventually do. Until then, investors are happy to chase those past returns irrespective of the rich price of Treasuries. Fear and loathing of equities has fueled the appetite of Treasuries investors, and that fear and loathing is now entrenched after a fairly unimpressive decade long stretch for the US equities markets.

At 2.7% interest, you can hardly call a ten year Treasury any kind of a bargain. Throw in taxes, and barring a protracted stretch of global deflation, chances seem pretty good that investors will take real (if not nominal) losses if they hold ten year Treasuries till maturity. And between now and 2020? Interest rates and inflation are at exceptional, almost historic lows, and either of which would, should it rise between now and 2020, decimate the principal value of a ten year Treasury. I will leave it for others to debate whether inflation will ever rise again, and whether the Federal Reserve will ever raise rates, but the point is, for assuming that risk, an investor who buys a ten year Treasury gets only 2.7% for his trouble. Not much compensation for assuming those risks (and I'm just going to assume away the risk of the US defaulting on its debt obligations, but hey, you never know, do you?)

Suppose you take a view that over time, earning 2.7% will not be a sufficient inducement for investors to continue to purchase and hold US Treasuries. Suppose you take a view that investors will, in time, exit nominal yielding Treasuries and other government debt in favor of investments that actually produce some sort of income and compensate investors for their time and willingness to assume risk. Why might this be the case? Perhaps a surprise uptick in inflation knocks Treasuries prices to their knees. Perhaps the Federal Reserve becomes more hawkish. Perhaps retiring baby boomers need income to survive, and the 2.7% yield on Treasuries simply will not do the trick. Any of these or other dynamics could make higher risk, higher yielding assets relatively attractive to a US Treasury, which could support higher prices for such assets over time.

What are some examples of higher yielding risky assets that MIGHT (underscore, MIGHT) perform well under such scenarios? Perhaps junk bonds ETFs, such as Ishares IBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG) or SPDR Lehman High Yield Bond ETF (NYSEARCA:JNK), which already sport yields in the 10% range. Preferred stock ETFs could benefit, such as PowerShares Preferred (NYSEARCA:PGX) which currently yields over 7%. Various master limited partnership closed end funds sport yields in the 6% to 7% range - including Tortoise Energy Capital Corp. (NYSE:TYY).

The downside to owning risky yield producing assets is that markets tend to suffer from bouts of risk aversion. Investors will often dump all risky assets indiscriminately during times of market upheaval - high yielding ones are no exception. And the chances for such upheavals seems pretty good. But if you chart issues such as HYG, JNK, PGX, or TYY against the S&P 500 for the last six months (including reinvested dividends), you will note that higher yielding risk assets have tended to outperform equities in terms of price, in some cases with less volatility.

In short, rotating capital out of Treasuries and into riskier income producing assets is obviously a chancy bet over the near to intermediate term. But over a ten year time frame? The ten year Treasury is so richly priced at the moment, there is considerable downside potential to holding that asset, and it provides very little cash flow to investors to cushion the potential blow. But over a longer time frame, the riskier income producing alternatives may, in fact, be less risky relative to Treasuries than meets the eye.

Disclosure: Author long HYG, JNK and TYY