What Is the Fool's Yield in High Yield Bonds?

TL;DR

The Fool's Yield refers to the phenomenon where chasing high yields in lower quality bonds often leads to disappointing returns due to heightened credit risk. Research indicates that investors seeking yields above 4% may encounter losses, particularly when bonds are rated between BB and B. Thus, investors should be cautious in their pursuit of high yields, as the risks may outweigh the potential rewards.

Transcript

DAN RASMUSSEN: I'm Dan Rasmussen, the founder and CIO of Verdad Advisors. And I'm here hosting a conversation on behalf of "Real Vision." We're talking today with Greg Obenshain, who's Verdad Advisors director of credit. Greg has spent the last few years studying the high yield bond and corporate credit market through a quantitative lens building o... Read More

Key Insights

• 😘 The fool's yield refers to pursuing high yields in riskier segments, resulting in lower-than-expected returns due to increased credit risk.
• ✋ Obenshain's bond-by-bond analysis revealed that riskier bonds performed worse than expected, while higher quality bonds delivered better returns.
• ↩️ The BB to B rated bonds marked the dividing line where acceptable returns turned into losses, debunking the belief that 7% or 8% yields were easily achievable.

Questions & Answers

Q: What is the fool's yield concept?

The fool's yield refers to the pursuit of high yields in riskier segments of the high yield market, often leading to lower returns due to increased credit risk.

Q: How did Greg Obenshain determine the dividing line between acceptable returns and losses?

Obenshain built a bond-by-bond database and analyzed the historical performance of bonds at different yield levels. His research showed that bonds trading in the lower half of high yield had lower returns, while those in higher quality segments performed better.

Q: What was the surprising finding regarding the fool's yield dividing line?

The dividing line between acceptable returns and losses occurred between BB and B rated bonds, much sooner than many people anticipated. This means that aiming for a 7% or 8% yield was much more difficult than expected.

Q: How does the fool's yield concept impact investors and pension funds?

The concept warns investors, especially pension funds, who allocate funds to riskier segments in search of higher returns. Engaging in riskier behavior, particularly with high leverage, may lead to unsustainable outcomes.

Summary & Key Takeaways

• Greg Obenshain introduces the concept of the fool's yield, which refers to the pursuit of high yields in riskier areas of the high yield market.

• He explains that in this fool's yield environment, investors often end up earning lower returns than anticipated due to the higher base rate of losses in these riskier segments.

• Obenshain highlights that last year, the dividing line between acceptable returns and losses was between BB and B rated bonds, surprising those who expected higher yields.