Disappearing Bonds and the Perils of Chasing Yield

Editors' note: MarketMinder does not recommend individual securities. The below is simply a broader theme we wish to highlight, not a recommendation to buy, sell, hold, sell short, free deliver, gift or otherwise transact in any securities mentioned.

We need to talk about bank bonds. And not in the "eek, they're crashing!" kind of way. That was last week. Our subject matter this time is some bank bonds in the UK and Europe that were cancelled, bailed in and defaulted, confusing the many investors who thought they were getting sacrosanct, infallible, high-yield investments. For anyone choosing investments for yield alone, whether you use high-dividend stocks, bonds, REITs, Master Limited Partnerships (MLP) or anything else with a regular payout, this is a timely reminder: No investment income is sacred, and risk-free return doesn't exist.

Thousands of folks learned this the hard way recently. In the UK, Lloyds Banking Group just called a tranche of bonds issued to shore up capital during the financial crisis. Many yielded over 10% and traded well above par value, basically bathing them in hallowed light. But they also cost Lloyds about £1 million per day in interest-money they could save if they called the bonds and borrowed anew in the open market at today's rock-bottom rates. So they redeemed them early. At par value, arguing the prospectus's terms and conditions allowed them to do so if the bonds no longer qualified as regulatory capital. The bond holders-primarily UK pensioners-challenged them and won, then lost the appeal, but will get a Supreme Court hearing in a month. If they win, Lloyds will pay a premium, but either way, retirees will lose double-digit yields overnight, with basically zero chance of replacing them.

Meanwhile, in Italy, savers are still reeling after the late-2015 rescue of four banks wiped out certain bondholders. The bonds in question were subordinated, which in plain English means they're the last to get repaid if the bank implodes, and among the first on the hook if the bank is bailed in under Europe's new bank resolution rules. Their default risk is inherently higher, and their prospectuses say as much. Contrary to widespread belief, they aren't covered by deposit insurance. But banks often pitch them to European savers as high-yielding alternatives to savings accounts, and many folks don't bother reading the prospectus (which, as you can imagine, is written in legalese and laced with sleep aid). Retail customers gobbled them up during the eurozone crisis, when banks were shut out of international markets, in some cases plowing most of their savings into them. When Banca Etruria, Banca Marche, Carichieti and Carife went under, many savers lost everything. One committed suicide. According to Italy's central bank, there are currently about €200 billion worth of these bonds still outstanding, and in most cases, savers can't redeem them early. They're stuck, and if more Italian banks are bailed in, bondholders could be in for more heartache.

Ordinarily, bond insurance (credit default swaps, or CDS) would be a viable solution for bondholders fretting rising default risk. But bond insurance doesn't always work. Some institutional investors learned that again this week, when they found out CDS will pay nothing on some Portuguese bank bonds made worthless by the central bank last December. These are the infamous bonds from Novo Bank, the artist formerly known as Banco Espírito Santo. They were transferred from the "good" Novo Bank to the "bad bank" when regulators decided the good bank needed a cleaner balance sheet. So instead of having a claim on a healthy bank's assets, these investors have a claim on a failed bank that has about zero chance of paying interest or principal. One would think this would constitute a credit event, a technical default, because there is really no other word for a bond rendered worthless overnight with no chance of a payout. But because the bond was officially transferred, the powers that be decided it didn't count, adding insult to injury.

Chances are you, dear reader, were not directly impacted by these three events. But consider them a free warning. There is no such thing as a guaranteed or safe yield. Heck, there is no such thing as a safe investment, ever, and anyone telling you otherwise is a fool or charlatan. If any security has a high payout, that high yield is probably compensation for higher risk. That interest or dividend payout can go at any time. Bonds can get called. Issuers can default. Companies can cut dividend payments. So can REITs, Business Development Companies and MLPs. High dividend payers can fail. Energy and Materials stocks' high yields might look shiny, but several big names (Kinder Morgan, Anglo American, Freeport-McMoRan, Glencore and Chesapeake Energy, to name a few) have suspended or cut dividends in recent months. Analysts expect more will follow suit. Financials were high-yielding throughout 2008, but share prices plunged, and eventually, those yields vanished. Energy MLPs' high yields are widely expected to go the way of the dodo this year.

I'm not anti-yield. Dividends and interest are fine. But you must do your homework, understand the risks, and think long and hard about whether they match your long-term needs and goals. A bond yielding 10% is lovely, especially when inflation is low. But in a time when benchmark risk-free^[i] bonds yield 2% or less, what does that high yield say? And, what happens when that bond matures or gets called? Then where will you find that yield? Where will your income come from? Reinvestment risk often gets short shrift, but it matters. If you rely on a high interest or dividend payment to fund your living expenses, you could find yourself in a tricky predicament without warning.

Chasing yield, in any corner of the market, usually adds risk you don't need. Though it might seem counter-intuitive, most folks don't need high-yielding investments to cover their living expenses. Dividends and interest are investment income, but they aren't the only solution for folks investing for cash flow. For most people, the better approach is to invest for total return-price returns plus dividends and interest-and sell stocks to raise cash to supplement dividends and interest as needed. This can keep you from over-concentrating in certain sectors and loading up on bonds with high default risk. You can diversify. Yes, this means selling your principal now and then, but that's ok. Investment principal isn't holy or untouchable. It's there, waiting to help you reach your goals. My advice: Let it, and don't be a slave to yield.