Why We Don't Chase Yield; Lessons from Puerto Rico
On June 29th governor Alejandro Garcia Padilla announced that Puerto Rico would not be able to pay it's roughly $72 billion in debts. This may come as news to most, but Puerto Rico has actually been contracting in inflation-adjusted terms since 2006 and it's economy is now 14% smaller than it was a decade ago. To add to the problem, Puerto Rico has been borrowing enormous sums of money giving it more municipal bond debt per capita than any U.S. state. With their economy declining and debt rising, many fled the country and now it's population is 10% smaller than 10 years ago. Out of this poor economic situation comes an important lesson in fixed income investing. Low yield environments that we have seen for the past decade often cause investors to "chase yield" in the markets by lowering their acceptable credit quality threshold. We can see this through the large inflows into high yield bond funds, also known as "junk bonds" on Wall Street. Another strategy employed by investors seeking higher yields was to move assets away from safer bonds to assets with stock-like risks such as REITs and high-dividend yield stocks. Larry Swedroe pointed out in a CBS Money Watch article How Chasing Yield Affects Expected Returns, that investors chasing higher yields did so at the expense of lower expected returns along with added outside risks.
This is not only true of individual investors, but professional money managers as well. Over the past few years, yields on Puerto Rican bonds have generally been much higher than higher credit quality municipal bonds of similar maturities. In total, bond mutual funds held $11 billion worth of Puerto Rican debt, another $15 billion held by hedge funds, and the remainder largely held by individuals. Now these investors are faced with the possibility of a default on their investments. As is often the case, higher yields are generally compensation for a higher-risk investment.
This is another lesson on why it's important to never take more risk than you have the ability, willingness, and need to take, because the markets will eventually test your discipline. Siena Wealth Advisors has never recommended holding Puerto Rican or high yield debt. We instead only recommend and invest in high-quality, investment grade bonds.