Three Things You Should Avoid When Reaching for Yield

March 30 2015

This month, Rabobank was the first Dutch bank to lower its interest rate on saving accounts below 1 percent. Other banks are expected to follow promptly, considering that over 25% of all outstanding European government bonds currently yield a negative interest rate. For the first time in history, there are companies borrowing money at negative rates.

Three Things You Should Avoid When Reaching for Yield

This month, Rabobank was the first Dutch bank to lower its interest rate on saving accounts below 1 percent. Other banks are expected to follow promptly, considering that over 25% of all outstanding European government bonds currently yield a negative interest rate. For the first time in history, there are companies borrowing money at negative rates. Savers in Germany and Denmark are already paying banks in order to deposit their savings with them. To make matters even worse; these are negative nominal interest rates. If we look at real interest rates, corrected for inflation, the situation is even more disturbing. Many are now desperately chasing yield, but this 'reach for yield' may lead to large personal tragedies and the loss of a large portion of their financial wealth.

#1: 'Junk Bonds' and 'Junk Bonds'-ETFs

'Junk bonds,' or 'high yield bonds' were never this overvalued. With zero interest rates on bonds worldwide, many investors have moved to riskier corporate bonds yielding higher interest rates. As a result, interest rates on 'junk bonds' have reached a historically low. And never were there so many private investors that put this much money in these kinds of bonds via exchange traded funds; ETFs.

The term 'junk bonds' originates from the 1970’s and 1980’s. Michael Milken, a former banker convicted of fraud, was crowned the king of 'junk bonds' at the time.

He financed corporate takeovers by putting a large amount of risky bonds on the market. Milken had very good connections, enabling him to find enough buyers for these 'junk bonds.'

Under normal circumstances, interest rates on these bonds are high. But due to the worldwide zero-percent interest rates set by central banks, interest rates on these 'junk bonds' have lowered.

Depositors, desperately looking for yield, choose 'junk bonds' ETFs as they appear very attractive to them. Safe bonds yield a low, or non-existent, interest rate. The nominal interest rate payments (6%) provided by these ETFs therefore look like a gift from heaven.

Do you know what happened in 1990?

The number of bankruptcies suddenly increased. For a period of ten years, an average of 2.2% of these bonds defaulted annually. In 1989, Drexel Burnham Labert, one of the largest traders of these risky bonds, went bankrupt and Michael Milken was convicted of illegal trading.

'Junk bond' king Michael Milken became a 'Junk bond' lapdog.

Do you know what may happen to your ETF?

An ETF, or exchange traded funds, is as liquid as the underlying assets are. And when things go wrong; 'junk bonds' becomes illiquid. When everyone wants to sell, and when the companies that issue these 'junk bonds' go bankrupt in large numbers, the market dries up and it is impossible to sell them. The result? The most spectacular price losses ever seen in bonds markets.

In other words, 'junk bonds' are a bad choice for private investors. 'Junk bonds' ETFs? An even worse choice.

#2: Day Trading with CFDs

I am often very critical about the AFM (Dutch Authority for Financial Markets), but they are right in warning investors for CFD products. In fact, CFD’s belong in a casino, not in an investment portfolio.

CFD stands for 'contract for difference' and is actually a bet 'against the house,’ without the underlying asset (a share, commodity or bond) playing any role in the transaction. These are often short-term contracts, for example for 24 hours, and it therefore has little to do with the art of investing.

These CFD’s look a lot like a U.S. phenomenon of the past, the so-called 'bucket shops.' They were immensely popular and the 'ordinary man' went there to speculate in shares and commodities. But in reality they were making a bet with the 'house.' No transfer of ownership of the underlying assets ever took place. The U.S. authorities intervened: in 1920 these trading houses had virtually disappeared.

Due to low yields, many private investors cannot resist the enormous promises of this type of derivative trading. Investors are being lured by potential returns of hundreds or thousands percentage points. However, there is a much larger chance that you will lose your entire principal. Do not play with leverage and short-term CFD contracts, if you are not sure what you are doing. You might as well bet your money on a football match.

#3: Tech Stocks

The popularity of tech shares is unprecedented. We read about absurd company valuations for corporations such as Instagram (33 billion dollars on a turnover of 700 million), Slack (2.8 billion), Snapchat (15 billion) and Pinterest (11 billion). It is hard to believe that these digital bulletin boards (Pininterest) or photo-apps (Snapchat) are worth billions without any noteworthy revenues being made.  

But since many retail investors know these platforms, or even make use of their services, 'investing in a Twitter share' is appealing. Given that the name is so well-known, the share in a way feels reliable and 'safe.'

A lot people will scratch their heads when valuations of these kinds of tech companies will be adjusted downwards, and when the current private equity boom (private equity companies finance these tech companies, hoping to recoup their investments by a later IPO) will come to an end. In many cases, private investors will then end up empty-handed. "Pocas nueces, mucho ruído," as the Spanish would say; “A big fuss about nothing.”

Do Not Focus on Yield, but on Wealth Preservation

In current circumstances, most people should no longer focus on yield, but on wealth preservation. In 2008, a lot of people chased after yield by depositing their savings at Icesave. They promised almost one percent point (1%) more than other banks did. The consequences are well-known. Icesave went bankrupt and savers lost most of their money.

If you are on the verge of falling for one of these three traps, keep in mind that this may be a dear mistake.

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