Reaching for a little extra yield in your “safe” asset class. Somehow that has always appealed to some investors who are not satisfied with the yield they get from a portfolio of diversified investment grade bonds. I suppose that has to be particularly appealing these days, with interest rates as low as they are, but considering the history of these efforts to “juice the yield a little bit,” perhaps caution is warranted.
In my professional life, I have seen a number of these schemes to get better yield in some complex strategy touted as low risk go south, costing people their jobs and reputations and costing investors a lot of money.
The most famous recent example
The Big Short[i] was a great book and a good movie, a true story which we have cited several times. Two very smart hedge fund managers (separately) saw a big opportunity in a big problem and made a killing.
In the early 2000’s mortgage regulations were loosened considerably to promote home ownership, and the bad credit mortgages that resulted were bundled in securities called “Collateralized Mortgage Obligations” (CMOs), magically transformed into investment grade[ii], and sold to unwary institutions. Then they started blowing up in 2007, and the huge losses nearly took down the whole financial system.
Our two protagonists had discerned that these mortgages were bound to fail, and they figured out how to sell the CMOs short. The rest is history.
And now we have Collateralized Loan Obligations (CLOs).
For an extra 1% or so, you get a pool of bad credit loans, an asset class that was in trouble as recently as last year, and potential illiquidity. Is it worth it? To me, it sounds like the same old story, only the names have changed. What do you think?[iii]
[i] Lewis, M., 2011. The Big Short.
[ii] If you have sufficient volume of bad credit securities, somehow it becomes good credit, apparently. Or so they said.
[iii] Pellejero, S., 2021. Issuance of Bundles of Risky Loans Jumps to 16-Year High. [online] WSJ. Available at: <https://www.wsj.com/articles/issuance-of-bundles-of-risky-loans-jumps-to-16-year-high-11621849782?mod=hp_lista_pos4> [Accessed 1 June 2021].
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