Demand for Hitmen and Yield

Contract killers are not typically hired simply because they are available. I won’t decide to kill my wife solely because Luca Brasi is around, even if he is offering a discount.  There has to be a perceived need for contract killing (as Byron Fisher sagely points out) — I have to want (a lot— given the risks) to kill my wife — for Luca to be in business. In other words, the general public must demand the services of contract killers before contract killers start supplying their services to the general public.

Thus demand will always create supply. There aren’t very many purported economic “laws,” and even fewer that are well-supported by the data — but this is one that has been true throughout human history, and I don’t expect it to change any time soon. If demand exists, entrepreneurs will create products and/or services to meet that demand. 

When demand is especially great, new kinds of (not-so-great) supply often emerge to meet it.  For example, when Wall Street investment banks had huge demand for CDOs generally but no ready outlet for the lower-rated tranches, they “created the investor” to buy that paper.  Accordingly, they became desperate to obtain more sub-prime mortgages to fuel their CDO machines, which caused mortgage companies to create riskier and riskier, stupider and stupider mortgages to meet that demand and thus inflate the housing bubble.  

Similarly, in times of historically low bond and related yields (and low rates generally), in an effort to kill off various threats to a portfolio and/or to satisfy income needs of various sorts, it shouldn’t be surprising that many investors are reaching for yield.  In so doing, many take on much greater risk and suffer much greater illiquidity in order to find a bit of yield. Reaching for yield is as old as the hills but often doesn’t turn out well. JPMorgan Chase’s admission yesterday of a $2 billion trading loss in derivatives — still unrealized at this point, which means they have not yet been able to unwind all the trades and that the losses may continue to grow (explained here) — was based upon just such a reach (as Charles Peabody describes for Bloomberg TV viewers here).

Whether we are talking about munis, junk, MLPs, bank loans, emerging markets debt, traded REITs, non-traded REITs, or even high quality dividend stocks, reaching for yield adds significant risk and often has dreadful consequences. In March 2009, after General Electric’s stock price had plunged 72 percent in a year, that bluest of blue chips added insult to investors’ injury by slashing its dividend by 60 percent. Whether the issue is credit risk, interest rate risk, complexity risk, currency risk, liquidity risk or market risk, adding risk is — well — risky.

Savvy investors should consider every possible avenue for investment success, including the “yield vehicles” outlined above.  But they should do so in the context of overall value. When investors’ focus is on yield, return and growth to the exclusion of risk, the outcomes are often bad ones. Sometimes these risks can even be fatal, as Luca Brasi discovered similarly (see below).

 

Yield is in great demand, which suggests that it will tend to be overbought and that the vehicles created to meet it should be scrutinized carefully (think sub-prime mortgages, for example). Reaching for yield is an expected play in times like these.  But before you try it, be sure it’s truly a value play and not a careless reaction to difficult times.