Yield, the Oldest Scam in the Books

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This blog is produced by David Merkel CFA, a registered representative of Finacorp Securities as an outside business activity. As such, Finacorp Securities does not review or approve materials presented herein. By viewing or participating in discussion on this blog, you understand that the opinions expressed within do not reflect the opinions or recommendations of Finacorp Securities, but are the opinions of the author and individual participants. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security or other instrument. Before investing, consider your investment objectives, risks, charges and expenses. Any purchase or sale activity in any securities instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Finacorp Securities is a member FINRA and SIPC.

David Merkel

At my blog there are two main purposes: teaching investors about better investing through risk control, and tying all of the markets into a coherent whole.

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There are two ways to fleece (cheat) someone: appeal to their greed, or appeal to their fear.  But the most effective approach that I know of is to appeal to elderly investors who did not save enough, and are finding it difficult to make ends meet.  They don’t want to take big chances, but they do need the yield.

Before I go on, what is yield?  This sounds like a dumb question — the simple answer is the percentage of money remitted to investors relative to the market value of the security.  And that is true as far as it goes, but there is more wood to chop here.

Yield is four things:

The risk free return on capital over a specified horizon. The return required in order to induce someone to give up liquidity if the bond is not marketable. The return required to take on any optionality, whether call or put risk, conversion, prepayment or extension risk. The return needed to compensate for the possibility of default.

I have written before against buying structured notes from Wall Street.  Retail investors, take note.  Wall Street knows more than you do, and you are the patsy at their poker table.  The deck is stacked against you.  Avoid buying their products where they try to sell you an enhanced yield in exchange for a less certain return of principal, whether due to default, prepayment, call, or extension.

Though there are instruments that are undervalued, yielding more then they ought to, most of the time high relative yields indicate high risk.  Stretching for yield is usually a mistake.  With bonds and preferred stocks, it usually means more credit risk.  With equities and LPs, it usually means paying out more than the underlying cashflows from operations can handle, which is another form of credit risk.  Dividends can be reduced quickly if the cashflows can’t support them.

Now I turn to the article that drove this piece: Nonlisted REIT Sales Get Heightened Scrutiny by Finra.  Anytime you buy a security without a secondary market, you leave yourself at the mercy of the company.  Liquidity is poor, but the poor fool who buys these investments does not consider how much extra yield he needs to compensate for illiquidity.  Instead, he looks at his income needs, and buys.  Do you really want to play in someone else’s casino?  The casino analogy is apt, because the company controls the dividend payout and the buyback price.  Worse still, they have a better idea of what the asset are worth than the investors do.  Those with short-term cash flow needs are in a bad spot investing with them; they will not get the true economic value of their holdings.  (But, they should have planned for it — anytime one takes on illiquidity, one should make sure that there is enough liquidity elsewhere to compensate.)

With listed REITs, an investor has real estate equity or debt levered up through borrowings.  A nonlisted REIT is the same, except that there is no third party market to buy and sell shares.  You owe your soul to the company store, though you the the creditor, not the debtor.  My view is simple here: don’t buy into roach motels for cash, where the cash goes in easy, and comes out hard, unless you can negotiate your own terms.

Don’t give up liquidity without fair compensation.  I am happy to say that in my personal and professional investing career, I have never taken a loss off of illiquid investments.  Why?  Because they have to be bulletproof to me before I invest.  They must have table stability, not just bicycle stability.  Can they pay me back when liquidity is scarce?

-==–==–=-=-=-=-=-=-=-=-=-=-==-=–=-=-==–==–=-=-==–=-=

I have been through three exercises at the firm I work for where a life settlements securitization has been proffered to us as a great way to start up a securitization business.  Every one of them was bogus, and I protected the firm by telling them not to do the deals.

The life settlements seemingly carry a lot of yield, so it takes some backbone to suggest that there is not enough yield, or that capital losses will eat up yield, so the deal should not be done.  For a time, I ended up saving the firm.  The lesson is this: in investing, ignore yield to the greatest extent possible.  Focus instead on earning a good return, with safety, and ignoring the payout.  It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term.  It is easier to earn money off of taking equity risk than credit risk.

So, aim for best advantage in investing.  Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to.  Yes, it is a lot more work, but it is work that you should be doing.

This entry was posted on Thursday, June 3rd, 2010 at 1:43 am and is filed under Bonds, Portfolio Management, Structured Products and Derivatives. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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Copyright David Merkel (c) 2007-2010 Disclaimer: David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here or on RealMoney is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of. _qacct="p-37GEOW7Y76-VY";quantserve(); var sc_project=2500170; var sc_invisible=0; var sc_partition=23; var sc_security="aacd9be3"; View My Stats

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Before I go on, what is yield?  This sounds like a dumb question — the simple answer is the percentage of money remitted to investors relative to the market value of the security.  And that is true as far as it goes, but there is more wood to chop here.

Yield is four things:

I have written before against buying structured notes from Wall Street.  Retail investors, take note.  Wall Street knows more than you do, and you are the patsy at their poker table.  The deck is stacked against you.  Avoid buying their products where they try to sell you an enhanced yield in exchange for a less certain return of principal, whether due to default, prepayment, call, or extension.

Though there are instruments that are undervalued, yielding more then they ought to, most of the time high relative yields indicate high risk.  Stretching for yield is usually a mistake.  With bonds and preferred stocks, it usually means more credit risk.  With equities and LPs, it usually means paying out more than the underlying cashflows from operations can handle, which is another form of credit risk.  Dividends can be reduced quickly if the cashflows can’t support them.

Now I turn to the article that drove this piece: Nonlisted REIT Sales Get Heightened Scrutiny by Finra.  Anytime you buy a security without a secondary market, you leave yourself at the mercy of the company.  Liquidity is poor, but the poor fool who buys these investments does not consider how much extra yield he needs to compensate for illiquidity.  Instead, he looks at his income needs, and buys.  Do you really want to play in someone else’s casino?  The casino analogy is apt, because the company controls the dividend payout and the buyback price.  Worse still, they have a better idea of what the asset are worth than the investors do.  Those with short-term cash flow needs are in a bad spot investing with them; they will not get the true economic value of their holdings.  (But, they should have planned for it — anytime one takes on illiquidity, one should make sure that there is enough liquidity elsewhere to compensate.)

With listed REITs, an investor has real estate equity or debt levered up through borrowings.  A nonlisted REIT is the same, except that there is no third party market to buy and sell shares.  You owe your soul to the company store, though you the the creditor, not the debtor.  My view is simple here: don’t buy into roach motels for cash, where the cash goes in easy, and comes out hard, unless you can negotiate your own terms.

Don’t give up liquidity without fair compensation.  I am happy to say that in my personal and professional investing career, I have never taken a loss off of illiquid investments.  Why?  Because they have to be bulletproof to me before I invest.  They must have table stability, not just bicycle stability.  Can they pay me back when liquidity is scarce?

-==–==–=-=-=-=-=-=-=-=-=-=-==-=–=-=-==–==–=-=-==–=-=

I have been through three exercises at the firm I work for where a life settlements securitization has been proffered to us as a great way to start up a securitization business.  Every one of them was bogus, and I protected the firm by telling them not to do the deals.

The life settlements seemingly carry a lot of yield, so it takes some backbone to suggest that there is not enough yield, or that capital losses will eat up yield, so the deal should not be done.  For a time, I ended up saving the firm.  The lesson is this: in investing, ignore yield to the greatest extent possible.  Focus instead on earning a good return, with safety, and ignoring the payout.  It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term.  It is easier to earn money off of taking equity risk than credit risk.

So, aim for best advantage in investing.  Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to.  Yes, it is a lot more work, but it is work that you should be doing.

This entry was posted on Thursday, June 3rd, 2010 at 1:43 am and is filed under Bonds, Portfolio Management, Structured Products and Derivatives. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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Copyright David Merkel (c) 2007-2010 Disclaimer: David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, or in my writings at RealMoney is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here or on RealMoney is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of. _qacct="p-37GEOW7Y76-VY";quantserve(); var sc_project=2500170; var sc_invisible=0; var sc_partition=23; var sc_security="aacd9be3"; View My Stats

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