ebook essays pieces of the puzzle
Monday, April 18th, 2011
junk for grandma

Today’s title comes from a MarketWatch piece by David Stockman.  He said, “There is no monetary tradition whatsoever that says the way back to U.S. economic health and sustainable growth is through herding Grandma into junk bonds and speculators into the Russell 2000.”

Let’s set the macro debate aside and look at the micro, where Stockman is spot on about what happens.  Many retail investors, especially older investors, are sold “yield.”  Never mind that there are conflicting definitions of yield that are used in such sales, that yield and return concepts are casually and confusingly interchanged, or that the risk of principal loss is often not highlighted.  Yield sells — it always has.

It especially sells on a comparative basis.  Grandma no doubt pines for the 1980s, when short-term rates from the Treasury were in the double digits.  But even in mid-2007 the situation was quite a bit different than it is today.  A three-year CD was pushing 5% and junk bonds only offered a couple of points extra, so there was not a great reason to reach.  Now the spread is much greater and the absolute return on that CD is pretty paltry.  The temptation is there and a friendly salesman should be able to make the case.

I left out of the chart above what also won’t be there in his sales package — evidence of the negative returns that happen when you get on the wrong side of the credit mountain.  The migration might not be from a three-year CD to junk bonds, but if you live on yield, you’ll grab for something.  It happens every time and is happening now.  The rest of the story is yet to be written.  (Chart:  Bloomberg terminal.)