Tag Archives: Yield Spreads

Managing “Mr. Market” With Howard Marks

I went on a long distance drive for Thanksgiving – Houston to Southern California and back. I don’t recommend doing that unless you have two full weeks. It’s 1500 miles each way, which means you should allocate six days to driving.

I didn’t allocate my time well, because I had around 10 days, not two full weeks. That meant I spent more time driving than visiting. But on the drive I managed to catch up on some podcasts, and one that stands out is Meb Faber’s interview of Howard Marks. Marks is a legendary investor and has a new book out called Mastering the Market Cycle. A few things stand out about the interview. Cycles are related to risk-taking and behavior, and they are often debt-driven. A rising stock  market often occurs simultaneously when lending standards relax. That’s why junk bonds and real estate often move in tandem with the stock market in what have come to feel like “risk-on, risk-off” trends.

Can anyone master these trends? First, don’t expect to time things exactly right. Marks raised an $11 billion fund in 2007-2009 that capitalized on bonds and other instruments of near-bankrupt companies. He’s frank with Faber that he didn’t know what was happening with CDOs or mortgage-backed securities; he didn’t have the precise insight that Michael Burry or Steve Eisman did, for example, in shorting mortgage-backed CDOs. But he saw deals being done everyday that didn’t make sense to him and reflected an increasing indifference to risk. In late 2008, he started putting money to work, buying distressed debt without knowing where the bottom was. Investors trying to time market cycles should understand that capturing tops and bottoms isn’t the goal. Buying on the way down and selling on the way up are difficult enough – and they will allow you to reap plenty of reward.

Another lesson for individual investors is that they should lessen their moves. Stop trying to be all in or all out of the market. Stop trying to be precise about timing; seeking precision can get you into trouble. As things get more expensive, your bias should be toward selling; as they get cheaper, your bias should be toward buying. It’s all about putting probabilities on your side, not timing full entries and full exits precisely. This part of the interview reminds me of Ben Graham’s discussion of the “enterprising investor” in his classic book The Intelligent Investor.

The enterprising investor doesn’t maintain a balanced or 60% stock / 40% bond mix at all times. Instead, he calibrates upward or downward between 75% stocks and 25% stocks. In other words, Graham counsels the most adept and studious investors never to be all in or all out, and Marks basically does the same thing. One has to be humble in trying to manage Mr. Market, Graham’s fictional, manic-depressive fellow one should think about when assessing markets.

A corollary to these lessons is that cycles can last longer than you think, and Marks is honest again that his caution in recent years has cost him. That’s not a reason to dismiss his wisdom; it’s just an acknowledgment that you shouldn’t seek precision. The current rally in stocks, corporate bonds, and real estate has gone on for almost a decade now. It feels long in the tooth, but that doesn’t mean it can’t go on longer. I’ve noted that the Shiller PE (stock prices relative to past 10-yr average earnings), for example, is in the low 30s, levels seen only in the run-ups to 1929 and 2000. But in 2000, the metric hit 44. There’s no law saying it can’t do that again — or even go higher this time. Marks mentions that it feels like the 8th inning now. But he also notes that final innings can last a long time, and games can go into extra innings. Again, a lot of patience is required whether you keep a steady allocation or whether you manipulate your allocation according to your understanding of cycles.

Marks says investors should set target allocations. But then they can deviate from them – as long as they know what they’re deviating from. So a classic balanced (60% stocks, 40% bonds) investor can go down to 50% or 40% stocks at this point, for example. Last, nobody should try timing cycles without being a keen student of market history. Too many investors try to time markets without having seen even one full market cycle. They don’t understand that things play out a little differently each time, and that they need to have patience. Timing market cycles isn’t easy even for Marks, and he’s had a 50-year career at this point. Everyone will have to calibrate to their own taste and temperament, but everyone should resist the temptation to make extreme moves. My own opinion is that smaller investors should also do this under the guidance of a professional. Don’t misallocate your assets the way I misallocated my time for this Thanksgiving trip. And call us if you have questions about how we allocate portfolios.

The Dumbest Bet in Finance

In this past weekend’s Real Investment Advice Newsletter, I wrote about financial advisor Larry Swedroe’s excellent article on the “Four Horsemen of the Retirement Apocalypse:”

  • low stock returns,
  • low bond yields.
  • increased longevity; and,
  • higher healthcare expenses.

In his article, Swedroe mentions that high yield (junk) bonds won’t save investors, who haven’t historically been rewarded well for taking on their risk.  Swedroe also says high yield bonds correlate well with stocks, which means they don’t provide much diversification.  Swedroe writes from the point of view of modern portfolio theory, which looks for ways to increase volatility-adjusted returns in a portfolio. In this post, I’ll treat junk bonds a little differently, showing why now is a terrible time to own them. My analysis doesn’t completely contradict Swedroe’s though; it supports his thesis that stocks and junk bonds are highly correlated.

Unlike Swedroe, I don’t dislike junk bonds per se. These loans to decidedly less-than-blue-chip companies are just like any other asset class. They can be priced to deliver good returns, as they were in early 2009, or not.

Right now, they’re not.

Everyone looks at junk bonds initially by observing the starting yield or yield-to-maturity. Right now, the iShares High Yield Corporate Bond ETF (HYG) is yielding 5.53%. That can look attractive to some investors. After all, where else can you get over 5%?

Other people look at the spread to the 10-Year U.S. Treasury. 5.53% is around 2.7 percentage points more than the 2.8% yield of the 10-year U.S. Treasury. That might look find to some too. Of course, a little bit of research shows that spread is lower than the historical average of around 5.7 percentage points.

Still, investors seeking higher yield may be undisturbed by a historically low spread. Some people need the extra yield pick-up over Treasuries, however small it might be by historical standards, and that’s enough for them to make the investment.

Yield Isn’t Total Return

There’s one extra bit of analysis, however, that should make investors think again about owning junk bonds – a loss-adjusted spread. The problem high yield investors often fail to consider is that junk bonds default. And that means the yield spread over Treasuries isn’t an accurate representation of what high yield investors will make in total return over Treasuries. It’s easy to forget about defaults and total return because defaults don’t occur regularly. They tend to happen all at once, giving junk bonds a kind of cycle and encouraging complacency among yield-starved investors during calm parts of the cycle.

Default rates for junk average about 4.2% annually, according to research from Standard & Poor’s. And investors have typically recovered 41% (or lost a total of 59%) of those defaults, according to this Moody’s study from 1981 through 2008. That results in an annual loss rate for an entire portfolio of around 2.5%. So the iShares fund’s 5.53% yield isn’t quite what it seems to be. In fact, if we subtract 2.5 from 5.53, the result is 3.03, meaning investors in junk bonds are likely to make only 20 basis points more than the 2.8% they could capture in a 10-Year U.S Treasury currently.

Now, a more careful analysis should consider an “option-adjusted” spread, which accounts for the fact that issuers can call bonds prior to maturity and lenders or bondholders can sell bonds back to the issuer at prearranged dates. This adjustment usually adds something to the spread, making higher yielding bonds slightly more attractive. So we took the options adjusted spread data, and adjusted it for an annual loss rate of 2.5 percentage points. Remarkably, there have been times such as immediately before the financial crisis when investors weren’t making anything on an options-adjusted basis above Treasuries to own junk bonds. Now at least it’s around 1 percentage point.


Still, even with the option adjustment, one percentage point over Treasuries is still very little, especially considering that the option-adjusted spread we used compares a junk bond index with Treasuries. In other words, the 0.50% expense ratio of most junk bond ETFs isn’t factored into the equation. At a 0.50% or so yield pickup over Treasuries, investors just aren’t making enough from junk bonds to justify owning them. Also, advisors pushing junk bonds on yield-hungry clients aren’t doing much due diligence. The mark of a good advisor is one who can say “No” to a client and bear the risk that the client will go to another advisor doing less due diligence.