May 2014

“Reach for the moon, 'cause even if you miss you land among the stars.”

-Author Unknown

It is graduation time in America, and on high school and college campuses across the nation, audiences are hearing inspirational quotes, like the one above. We at Talbot Financial like graduations. We like graduates even better. Graduates and investors, however, should not reach for the same things.

Reaching for the moon...perfect. Reaching for yield...probably not a great idea.

The problems occur when investors desiring better returns tend to forget basic risk/reward analysis that is so important in the long run. Let’s look at some of the sectors that look like a “reach for return” not worthy of the risk.

High-Yield (aka junk) Bonds

Rarely have we seen junk bond investing as popular as it is now. Yet, Moody’s comments, “the quality of covenants that govern high-yield corporate debt are at all-time lows.” This notwithstanding, investor appetite for the comparatively “fat-yields” seems insatiable as the junk-bond market has almost doubled to over $2 trillion since the 2008-2009 credit crisis. And all this “new money” is coming in at almost historically low spreads to treasuries.

This phenomenon is not limited to the US. Demand for Spanish and Greek bonds has soared. Spanish 5 year yields are now on par with US Treasury yields. And while we are hopeful for southern Europe’s continued recovery, both Spain and Greece still have over 25% unemployment rates, and don’t seem to warrant “safe haven” status.

Low-Yield Bonds

One would think that “low-yield” would equate to low-risk. On the very short end of the yield curve, we agree. However, the longer we venture out on the yield curve, we see a higher risk of principle deterioration over the coming years. At current levels, we see no “investor friendly” returns in the bond market.

As institutional bond manager Jeff Gundlac puts it, “There is interest-rate risk that’s just being masked by fund flows....if they (bonds) start to suffer losses, you really wonder who’s going to buy them.” We wonder as well. Too little return for risk here!

Emerging Markets

Everyone knows that smaller, emerging countries like Vietnam can grow faster than a mature economy like the US. The story of 7-8% GDP growth coupled with “sky is the limit” projections form the basis for “diversifying for safety” strategy. Throw in the fact that a Vietnamese 10- year bond is currently paying 8.7% (compared to about 2.5% in the US) and the temptation to reach for yield grows. (There are a myriad of reasons that these bonds offer an 8.7% yield.)

The risks here are plentiful. There is currency risk. There is political risk. There is interest rate risk. There is credit quality/default risk. When an investor throws all this into the soup, an 8.7% yield can quickly become zero. Or, even worse, in the event of a currency crunch, the pattern may look like this:

  • A countries economy sours.
  • Social unrest follows.
  • The now “unpopular” government changes.
  • Banks have liquidity squeezed.

In the ensuing years, the models did not accurately predict the market performance and “systematic sell” programs found themselves eating into their seed corn (principle). Eventually, many investors abandoned the strategy (usually too late) out of necessity. These poor(er) investors then spent years in the “Investment ICU” trying to get back to financial health.

There are other “reaching for yield” sectors, but we hope the point is made.

The reality is that investing in companies makes more sense today than investing in stocks....or investing in stories.

Strong balance sheets. Experienced and proven management teams. Reasonable valuations. Dependable dividends. Visibility of future earnings. You’ve heard all this from us before....and likely will hear it again, because we believe it is currently the best solid long term strategy, given the choices we have today.

Finally, we continue to believe that the “boring ol’ US” offers the most compelling investment environment; especially in the large-cap multinationals where we can get international exposure combined with the safety of U.S. GAAP accounting and regulation. The growth of America’s domestic oil production is a very real—and powerful—national economic driver. It is also reliable energy—something Europeans are certainly appreciating as the Russia-Ukraine situation continues to unfold.

Add to this the return of manufacturing to our shores (partly because of plentiful energy), a steady housing recovery, US corporate global expansion, and the emergence of new supporting technologies, businesses, and products and it’s actually not a very boring economy at all.

In short, we’ll leave the moon to the starry-eyed graduates and instead reach for investments that keep us grounded firmly in the here and now.

Happy investing!



View older posts.