Remember how cool the home run race was back in 1998? Sammy Sosa and Mark McGwire both broke Roger Maris’s single season record of 61 homers in a season. It was pretty easy to get swept up in this exciting story line, and it was fun too. It was a home run hitter’s game, and guys like McGwire, Sosa, and later Barry Bonds ruled the headlines.
In hindsight we were overlooking one big thing: they were all taking performance enhancing drugs. This period in baseball history is widely referred to as the Steroid Era, and now the only headlines featuring Bonds, Sosa, or McGwire are about not letting them into the Hall of Fame to punish them for cheating.
In the back of our minds, we all knew something was up in the late 90’s. However, the overarching story of the home run race and watching these players rip 500 foot home runs was too much fun. Did we really believe that hitters magically figured out a better way to hit pitching? Remember the story that Sammy Sosa cooked up about his bad wisdom tooth that apparently made it normal for him to go from looking like this to this? We all blatantly ignored the signs. As they say, “Chicks dig the long ball”, so we continued enjoying the fun, believing everything was awesome. This has a tendency to happen with stories we buy into. Bob Seawright explains that:
“Once we have bought-in to a particular narrative we’re mostly cheering our side on rather than doing substantive analysis. Our favored narratives become increasingly more difficult to falsify, even (especially!) when presented with contradicting fact.”
Josh Brown’s recent description of Third Avenue’s Focused Credit fund as a, “junk bond portfolio on steroids”, immediately made me think of baseball’s Steroid Era. I think a lot of the fund’s investors fell for some type of narrative as well: “Bonds are always safe investments” or “I need a higher yield to live on” come to mind here.
It’s pretty obvious at this point that the Third Avenue Focused Credit fund wasn’t your every day junk bond fund. When a fund is yielding 11.3% while investment grade corporate bonds are yielding 3.43%, long term treasuries are yielding 2.62%, and other high yield bond funds are yielding 6.32%, something is up.* People just don’t want to believe that yields are as low as they are, so they convince themselves they deserve or must have something better. Jason Zweig recently had this to offer on the subject:
“In short, you can’t get higher income just because you want or need to. There isn’t a safe way to make, say, 6% in a world of 2% bonds.”
“Want a higher yield? You’ll likely have to endure periodic losses and more price fluctuations. Want to avoid severe price fluctuations? You’ll likely have to endure a lower yield. Chasing yield after prices have risen is generally a terrible strategy, yet one that investors make on a consistent basis at the wrong point in the cycle.”
Unfortunately, humans have a propensity for loving good stories. If you believe you must have higher yielding investments, they’re out there for you if you’re willing to take more risk. It seems that many investors in Third Ave’s ‘roided out junk bond fund thought it would be “different this time” in terms of the usual risk-reward relationship we’ve grown used to seeing. There is no way to obtain significantly higher returns or yield without increasing the level of volatility in your investments. Despite this often touted rule, we see investors, perhaps aided by unscrupulous advisors or brokers, believe just the opposite quite frequently.
The reach for higher yield in a low interest rate environment has been a story for a while now, and it looks like Third Avenue’s Focused Credit fund is a textbook example of what can happen when you reach for yield. If you want the higher yield, be ready for more risk. Bonds tend to be regarded as a safe investment, but when you reach for yields higher than the market is currently offering, that description becomes less true. Junk bonds are a lot more correlated to the equity markets than higher quality fixed income, and as Josh said, Third Avenue’s fund wasn’t your average junk bond fund.
Kind of like the home run race in 1998, investors in Third Avenue’s Focused Credit fund probably had a clue that an 11.3% yield was fishy. Many decided to ignore that warning sign. If you recognize the risk for volatile events like last week’s to occur, by all means consider distressed junk bond funds. I’m not here to dissuade anybody from a strategy they fully understand. However, don’t fool yourself, or allow yourself to be fooled, into believing that funds with abnormally high yields are safe investments.
*Yields as of 11/30/15 for TFCIX, LQD, TLT, and JNK obtained via Yahoo Finance
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