The Problem With Chasing Yield in a Bond Bubble

There is a debate now as to whether there is a bond bubble or not. I think we are in a bond bubble. This bond bubble is not only for Treasuries and corporate debt, but across the yield spectrum. Too many investors are looking for yield, and their quest will end in tears.

As all these people are looking for yield, they push down those yields. Plus, the Federal Reserve is doing its best to keep interest rates low. So the end result is that IBM can borrow for three years at 1%. But really, these factors affect the whole spectrum of interest rates and yields.

For example, take a look at master limited partnerships, or MLPs. These vehicles are very popular with investors. But they are probably too popular. Mostly these companies own pipelines for oil and gas. They pay out most of their earnings to their unit holders. Yields are now about 5.5% for the popular Alerian MLP Index. A 5.5% yield looks good today. But about a year ago, MLPs paid about 8.8% on average.

But what happens if yields go back to 8.8%? The grim answer is that the price of an MLP yielding 5.5% would have to drop by 40% to produce a yield of 8.8%. In other words, these yields are anything but risk-free.

MLPs are too popular. They are overpriced, in my view. Most everything on the yield spectrum is similarly expensive. Investors are getting paid too little for the risks they are taking.

What’s happening in the junk bond market is another indication of a frothy market. Junk bonds are essentially higher-yielding corporate debt. People can’t get enough of them. In mid-August, we set a weekly record for the issuance of junk debt. For the year, volumes are up 80% compared to a year ago and will easily surpass the 2009 record.

All over, investors are scrambling for yield, and they are pushing down those yields to dangerously low levels. As a recent Wall Street Journal editorial – titled “Chasing Yields, Chasing Our Tails” – put it: “Nearly two years removed from the Lehman Brothers shock, bond investors are again ‘chasing yield,’ taking mounting risk for minimal future gains.”

In the end, I think it will end badly… I know it’s an unpopular message, especially regarding the yields. I get e-mails all the time from people who want yield. Well, I am calling it like I see it. And I’m telling you that you are going to get burned if you chase yield in this market.

Chris Mayer
for The Daily Reckoning