ebook essays pieces of the puzzle
Wednesday, July 27th, 2011
little harm can come

Yesterday, Josh Brown had a posting on The Reformed Broker about reaching for yield; as he notes, even FINRA is now issuing warnings.   I also saw a piece by Robert Lewis on Seeking Alpha which promoted investment in four BlackRock Credit Allocation Funds.  (In disclosure, I know Brown and his work, but all I have to go on regarding Lewis’ article is the text and the description of his background.)

In his article, Brown says that he’s favoring MLPs and higher-yielding stocks, and trying to steer clear of the black holes of risk that have attracted advisors and investors looking for yield.  His picks have risks of their own, of course, but Brown thinks they are more evident and quantifiable than those of some of the more popular vehicles.

As yield plays, Lewis recommends the BlackRock funds.  I have written in the past about some of the dangers of closed-end funds, including the misleading “managed distributions” of some and the craziness of buying them at a large premium to net asset value.  Neither of those factors is in play right now with the BlackRock funds.  They do use leverage, however, which (last I checked) can work either for you or against you.

For his strategy, Lewis says he “simply” looks to buy the one with the steepest discount, although he now owns all four.  He points out BlackRock’s reputation for credit work and says in a low-yield environment the funds “deserve attention as well as recognition.”  One thing that he stresses is that the funds are diversified as to industry and sector.  In closing, he writes, “diversification does count and little harm can come to investors buying a package of all four funds.”

I beg to differ.  First of all, if diversification is what you’re after, there’s no reason to buy four of these when one will do.  As is often the case with sister products, these portfolios are similar enough that there’s really no diversification benefit from owning all of them.  The interest rate and credit exposures are roughly equivalent in each fund and many of the bonds are identical (and held in similar percentages).

More importantly, “little harm can come”?  Compared to what?  I offer you the chart above, showing the performance of the largest of the three that were started in 2003, Fund II (PSY).  It appears with the iBoxx indexes for high yield and investment grade corporate bonds, the basis for the popular ETFs with the tickers HYG and LQD respectively.

Morningstar points out that the BlackRock funds had a change in strategy in 2009, so looking at history can perhaps be even more deceiving than it normally is.  But PSY is essentially a levered combination of the two indexes.  Given all of the money that’s piled into corporates the last few years, do you think if we get into a tough environment for credit that all of those owners will experience “little harm”?  Me neither.  (Chart:  Bloomberg terminal.)

fixing a hole

In the middle of a deluge is not the best time to be fixing a hole, yet that’s what often happens when the markets come under pressure.  Trying to anticipate the weak spots in your investment approach in advance is harder, but it can really pay off to not defer problems until you can’t avoid them.