There is No Free Lunch: A look at bond yields
Investing is hard. Anyone telling you different is a huckster.
If investing was so easy, we would all be billionaires.
Google "world's greatest investors" and you will see the same lists of 20 or so people. In a world with billions of people and hundreds of years of potential investors, that list is pretty darn short. That leads me to ask: Why are there so few great investors?
Some could be flat out lucky. Others could have started in the very early days of decade(s) long bull markets. But my view is that they are skeptics and understand risk better than most.
This post will explore the connection between risk and potential returns. It will also outline a few handy steps to help you chase the investing greats.
There is No Free Lunch
Most have heard the adage "There is No Free Lunch". The origin of this saying varies, but the meaning is universal.
It means that you will never get anything free without some cost. i.e. a restaurant may give you free food but only when purchasing a beverage. So, the food is not actually free. It costs you a beverage.
In investing you are not trading a beverage for free food. You are trading capital and potential returns versus losses.
When you invest you are dancing with risk and reward. You need to understand this, or you will likely never have investing success.
Bond Investigation (or what does “high yield” really mean?)
Investors place money in bonds because of consistent and periodic payments with some guarantee from the bond issuer that the principal will be paid back. Most view bonds as a conservative investment because of this predictable nature. But all bonds are not equal.
For example, a US Government Bond has the backing of the US Government. That means the bond will pay you unless the US Government collapses. Most investors assume that will not happen. Because of this implicit guarantee US Government bonds pay you quite little. You are trading higher payments (yields) for the safety that you will actually get paid.
Now let's talk about another flavor of bonds: high yield or "junk". If you were buying a TV, car, or furniture and the seller labelled them as "junk", you immediately think the product is low quality.
The issuer of a “junk” bond likely has high levels of debt, erratic or low revenue and profit numbers.
To make these bonds attractive, issuers pay investors more. In some cases a "junk" bond could pay you 3 times or more than a government bond.
The simple reason is because there is a real risk the bond issuer goes bankrupt or misses a payment. The increase in your payment compensates you for the higher risk.
This is worth repeating.
You get paid more because you might never get all your interest payments or even all your principal back!
Investors get excited when they see potential outsized returns. Greed sets in and they lower their guard to the risk that potential return holds. This lowering of the guard is what we want to help readers defend against. There are no free lunches in investing so do not become complacent.
How to Avoid Trapdoors
Now that you understand outsized potential returns carry higher risk. Let's discuss 4 steps to avoid investing trapdoors.
1. High Yields Need More Research
Next time you see a potential investment and the return seems too good to be true. Pause and prepare to do an investigation.
For bonds the investigation can go like this:
Compare the payments of the bond you are looking at with that of a US Government Bond with a similar maturity. i.e. the bond in question matures in 5 years. What does the US Government 5 year bond pay you?
You do this to get an idea of how much more the bond you are looking at is paying above the "risk free" rate. If the difference between the two yields is not large enough to compensate you for the additional risk, you just want to stop here and go for the government bond.
Investigate the Issuer
Bond rating agencies are around to "grade" bond issuers. Leverage the research they do for any immediate red flags.
Go one step further and decide if the issuer is in a business that you feel is poor or not doing well. Also look at revenues, profits and balance sheets. If they are increasing yearly, that is a solid signal they can likely keep paying their bond holders.
Check the News
See if there are any negative news items around the business, people in charge, or recent earnings.
You are looking for red flags that may impact the issuer business. You may even find third party research reports about the issuer. Leverage the work others have done to help you build the case for or against the issuer.
Thumbs Up Or Thumbs Down
The above investigation likely eliminates 90% of the bonds you will look at. For the remaining 10% it is decision time.
Did the investigation make you feel comfortable the issuer will be able to pay you?
If so, consider a small "test" buy. Over time you can always add more to the investment. If not, do nothing and revisit at a later date to see if a second investigation gives you more confidence.
2. Know Your Exit Plan / Signal
Before entering any investment. You need to have an idea of what your exit plan or signal is. Both for positive and poor investments.
For bonds the plan is usually to hold until maturity. You bought the bond for the predictable interest payments. Assuming there are no major changes to the bond issuers business. Sit back and collect the money.
In the unfortunate event there is a major incident at the bond issuer. i.e. Revenues start to dive, or there are other financial constraints. You should rerun the investigation steps. If you come away still having confidence in the issuer nothing to do. If you no longer have confidence. You may need to consider selling the bond.
3. Invest in What You Understand
Lynch says you should only invest in industries and companies you understand. i.e. if you have a specialized background in tech, you may consider investing in tech companies.
Warren Buffet says, “never invest in a business you cannot understand.”
He believes you need to understand how the business operates and works. That gives you insight to if a company is of value and has ability to pay bond holders.
In both cases - your real life experience and knowledge can provide more value than you give credit. When investigating a bond issuer. Ask yourself, "do I understand how they make money and could run into trouble?"
4. Tips Are a Dime a Dozen
Investing for some is a form of gambling. We recently saw this with the increase in day trading during the COVID pandemic.
By nature people want to be winners. The problem is that humans have a tendency to only talk about their wins. While hiding their losses.
Because of this you should be skeptical of tips. It makes more sense to do your own research and form your own opinions. Not getting caught up in hype and following the crowd. Think back to the great investors. Are they out there telling everyone how awesome they are? Or what they are planning to buy? No - they focus on their game. Not pitching you on why you should buy the stock they are in.
In closing I want to restate that there are no free lunches. Above average yields carry higher risk.
Be strong against human nature to lower your defense in favor of greed. Commit to investigations when returns are above market average. Leverage expertise of others to help you come to your conclusions.
Becoming a great investor takes effort and determination. The steps outlined in this post will help you in your journey and always remember InterPrime is here to discuss ideas with you.
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