Revisiting Yield Products

by: Roger Nusbaum

This blog started in 2004 and back then markets were functioning normally (mostly). Equities were mostly moving higher even if returns were lumpy, and there was no speculation about which would be the next country to need a bailout. It was not a riskless environment, but the risks confronted were rather pedestrian compared to what they have been since 2007.

Back then I used to write a fair bit about what I'll refer to as yield products. My take on these was that owning one or two types of products in moderation was a good way to kick up the yield of the portfolio, and if something horrible happened then a modest allocation would not devastate the portfolio. We owned two of these in a very modest weight, like 2% each: a call writing fund and an infrastructure trust.

Both of them worked for a very long time, as did most of these types of products in the various yield product segments. Then the crisis started to unfold and the market started to roll over and many yield products blew up in dramatic fashion. These types of products have blown up before, but pre-2008 a blowup was 20-30%, which was then usually recovered over some length of time. In the financial crisis many of these products dropped by 50-60% and have not come anywhere close to recovering their pre-crisis levels. Many of them have been "working," as one might expect or hope for, since bottoming out, in that they have been making their payouts and trading with pre-crisis volatility -- but still down a lot from 2007.

If they are making their payments and the volatility is back to "normal" then it is reasonable to take another look at these and decide whether any exposure is warranted. Just as in 2004-2007, anyone wanting to dabble in these should keep allocations modest because at some point they will blow up again. A 2008-style blowup is probably (hopefully) unlikely; but every few years it is likely that they will take a 20% or so hit. When you have a 5% exposure to things that blow up (and again, in the past they usually came back) it is merely a source of frustration, not a back to the drawing board situation.

So what the hell am I talking about? Here is a overview of a few segments in the yield product world but there are more than the following.

First is the call-writing, put-selling closed end funds. For a while these things were insanely popular, with CEF IPOs coming just about every week there for a while. I looked at a chart of four of them (these are easy for you to find on your own and they are mostly interchangeable), I chose the symbols randomly from memory and in the last five years three of them are down 50-60% and one was down 33% so they all fell a lot had some comeback in 2009 and then have meandered sideways for a while but then rolled over in 2011. For the last year they are down 20-30%.

I also looked at a few airplane leasing companies. This business seems simple enough in that many airlines lease planes but the companies are very transaction oriented, similar to infrastructure trusts, and markets need to be functioning in order for the companies to do what they do. Markets seized up for a while there in 2008 and these stocks got crushed. The three I looked at bottomed out with 80-90% declines but for the last two years are up an average of 20%. Only two of them pay dividends and they have been paying them.

Next I took a peek at three large closed end high yield bond funds. They have all traded fairly closely together; down 60-80% at the worst of the crisis, down 20% for the last five years and for the last two years they range from flat to up 10%. The yields all range from 7-11% and the funds have been paying consistently.

Lastly I looked at a few of the tanker stocks. Again these seem simple enough but collectively they are overly cyclical in terms of reacting to economic activity. They seem to have been punished every which way but loose, some are paying dividends now, some are not--they've really been on a wild ride including over the last year where the declines for the few I looked at ranged from 35-50%.

If you are interested in any specifics they are easy to find. The idea with this post is merely to revisit the space. These types of products worked just fine, then they blew up, the blow up is over and they might work again (you can decide for yourself). One point that I've tried to make before is that occasionally you need to go away from some market segment for a while (I've felt that way about Treasuries for several years and we don't own any now) for whatever reason -- but that does not mean you should completely lose touch.

In terms of owning just one yield product, the above seem to have different fundamentals driving them, have some vulnerabilities in common and some unique vulnerabilities. They also have different volatility characteristics -- the shipping stocks are shockingly volatile for my tastes, I'm surprised that the airplane leasing stocks have done well, and impressed by the resiliency of high yield funds.

Obviously the various ups and downs of the products mentioned above did not include dividend. If you actually investigate any yield products you would factor in the yield in order to get a more precise understanding of the total return, but for purposes of this post the numbers are apples to apples.

This was about process, about revisiting things that I used to pay a lot more attention to in order to start figuring out whether any of these have a place in the portfolio and should be investigated further.