More on my fascination with high yields
I wrote a week or so ago about how on fire Bill Gross, PIMCO's founder and co-CEO, has been on fire with his investments lately (see post: This guy is in a zone). This week's Barron's contains an interview with him from its annual Roundtable. Bill Gross is an extremely intelligent, successful individual. When he talks, I listen. Here is a link to the piece for anyone who's interested: Rocky Road. I will get to some interesting quotes from it in a minute, but first I wanted to discuss my interest in high yield instruments.
After becoming disenchanted with investing for yield several years ago when the Fed Funds rate was low, risk premiums had almost completely evaporated, as a result of the massive amount of leverage being employed and the historically low default rate, my initial reentry into the high yield sector came in late 2008. I initially became interested in the bonds of companies that the government is wasting our tax money to keep afloat several months ago. I chose bonds because theoretically they the safer than preferred and common stock because they are higher up the ladder and get paid first if a company goes belly up.
At the height of the market panic late last year, I bought small positions in American General and CIT Group bonds that featured astronomical yields. I have been sticking with small positions in these areas because I fully realize that these are risky companies that could easily implode. By placing lots of smaller bets in the sector I won't get hurt too badly if a company or two completely falls apart.
At the time, American General's 8.45% Senior note due 10/15/09 was trading at $640/thousand. After yet another government cash injection to AIG, it has since risen to $820/thousand for a tidy 28% return. I plan on holding it to maturity though (too bad I didn't buy more, but that's always the case with investing I suppose).
I also paid $517/thousand for the CIT Group 5.40% Senior Note due 03/07/13 thinking that this is just the sort of company that the government needs to get money flowing to because it will actually lend it out to businesses, rather than using the money to invest in Chinese banks or a whole host of disgusting things that some other major banks have been doing with government funds. That bet was right, CIT received a huge injection of TARP money and this bond has since risen to $780/thousand for a tidy 51% gain. Again, I plan on holding onto it for much longer, possibly to maturity.
After reading a Bill Gross interview with I believe Forbes in December I decided to expand my investments in the high yield sector to preferred stock. I placed several limit orders for preferred shares of banks. Unfortunately, the market calmed down somewhat and those limit orders did not begin to trip...until this week with the problems of Citigroup (C) and other nameless banks. I purchased preferred stock in two major banks last week and I expect to continue dabbling in the sector as long as I can get close to double digit yields.
We all make mistakes in life and in investing. I have certainly made my share of them over the past several years. It is the ability to learn from one's mistakes that separates the best from the rest. Hopefully I have learned from some of the losses that I have incurred in the past. I plan on buying as many bonds and stocks yielding 5% to 10%+ (and slightly lower than that for select blue chips like JNJ) as I can while the economy is a mess, locking in yields that we haven't seen in decades, and holding them to maturity in the case of bonds or for as long as possible in the case of stock. I don't care about capital gains any more. As I said the other day, if I buy high-yielding instruments properly the gains will be there if I want them, but I am now more focused on squeezing around 10% annual gains or so out of my portfolio.
Anyhow, here are Bill Gross quotes from the Roundtable article that I found interesting. Enjoy.
"Barron's: What grabs you in the bond market, Bill?
Gross: The government has issued hundreds of billions of dollars of Treasuries, but with yields of 2.5% on 10-year bonds and 0.8% on two-years, who wants to buy them? The market is beginning to address that question. Treasuries don't make sense at these levels. It will be at least 2010 before we see a hint of the Fed moving interest rates higher, simply because they are aware of the Japanese experience. They know the Japanese raised rates prematurely [after Japan's economy went into a tailspin in the 1990s].
Because of their low yields, government bonds are a trap. First the government lowers interest rates to the point where the investor receives a negative real return. That's where we are now. Second, the principal is depreciated through inflation. That's a hidden tax. The combination takes away any advantage Treasury bonds have, except under a deflationary scenario."
"This crowd seems a lot more worried about inflation.
Gross: There is a 10% possibility that government policy won't work and the U.S. will experience deflation à la the 1930s. That's not our prediction but it's more than a thin tail [low probability]. In that circumstance, long-term Treasuries yielding 3%-plus might make some sense....
Gross: The entire capitalist system is based on a little inflation. A little, but not a lot."
"Didn't risk-aversion peak in late November?
Gross: It did, as evidenced by stocks, credit spreads, oil, and currencies. But that's not to say it peaked for foreign central banks and foreign investors. They continued to buy Treasuries and forced them to overvalued levels.
The bond strategy we have followed for the past 12 to 18 months is to go where the government goes in terms of its purchasing power. The government is going to buy $500 billion in the next six months of the $3 trillion in agency mortgages outstanding. We have been buying mortgages. Through the TARP, the government has bought several hundred billion dollars of preferred stocks and attached equity warrants. The Treasury has accepted a 5% coupon for the preferred. Treasury Secretary Hank Paulson has decided 5% is a decent compensation for bank preferred, but the private market affords 11%, 12%, 13% yields on the same preferred stocks, which is remarkable. We are buying bank preferreds."
Author's note, and so am I.
"As for specific names, the best example of partnering with the government is the case of AIG. Some of us might agree it was a mistake for the government to bail them out, but it happened. The Treasury basically has taken $60 billion of the troubled assets off AIG's books and extended it a $50 billion credit line. It has extended a commercial-paper program to one if its major subsidiaries, International Lease Finance, worth another $2.5 billion. The government has given or guaranteed AIG close to $200 billion. The outstanding debt of the United States is $10 trillion, so 2% of everything the U.S. government has issued has gone to AIG. But here's the most incredible thing."
Author's note, YUCK!!!!
"You mean, that wasn't it
Gross: In the past three months, AIG bonds that are senior to the Treasury's $40 billion in preferred could be bought at 14%, 15%, or 16% yields. You can buy them now at 11% and 12%, under the cover of nearly $200 billion in guarantees, or 2% of the outstanding debt of the U.S. Normally you can't have a bond yielding 14% without significant potential to default. It is the most incredible example of value I have ever seen in the bond market. AIG has a 10-year bond that can still be bought at 12.5%. Technically it's A-rates, but realistically it's close to triple-A. We own a lot of them."