Over the last year, the strategy that has hurt investors (mostly large institutional ones) the most has been, for lack of a better term, the "yield reach." We'll define this strategy as buying a riskier income-oriented investment in order to attain a higher yield.

There's nothing wrong with assuming more risk in the hopes of garnering a higher yield. Heck, we've done it ourselves by allocating to "high-yield" (junk) bond funds, and even emerging market bond funds, in most of our model portfolios in the past. Ideally, investors  assume some extra risk in exchange for a large amount of extra yield. This is often best accomplished at a time when the greatest number of investors are scared to reach for extra yield. In most cases, if no-default-risk government bonds are yielding 5%, and investors can earn 15% in a basket of higher-risk junk bonds, absorbing the extra risk will prove profitable. Deep recession notwithstanding, the default rate on the higher-risk bonds should still be low enough to help you beat the risk-free 5%.

This strategy, however, does not work as well if investors take on extra risk in exchange for hardly any extra yield at all. This was the case in essentially all debt markets as recently as last year (and it's the main reason we cut back on junk bond funds in our model portfolios). After all, why own risky bonds for 6%, when safer bonds yield 4%? There's little margin for error in that equation.

For some strange reason, individual investors like to reach for yield after returns have been good (and defaults low) in whatever higher-yield asset class they're considering. At such a time, the risk appears low because investors think, "Well, look at all the extra money everybody's made by doing this."

This past performance (or rather past low default rate) logic led the smartest investors — big banks, Wall Street firms, mutual fund managers, and the like, to buy up just about every income-producing investment under the sun in recent years. Not only was the extra yield minimal, the extra risk was far higher than they could have imagined in even their wildest dreams (or rather, risk models). We even fell into this trap with one short-term bond fund that was supposed to be infinitesimally riskier than a money market fund — so much so, that we almost completely ignored what it was up to.

We'll start with mortgages — which remain the center of the storm. Default rates on mortgage debt were very low relative to the historical extra yield over no risk government debt. This led more and more institutional investors to make trillions of dollars of loans in order to reach for a little extra yield instead of settling for safer loans. Even questionable home borrowers were considered a much safer bet than the rates charged to them would seem to indicate. 

The problem was, mortgage defaults were low because home prices were rising. The behavior of home buyers in a falling home price environment (or when their payments were higher relative to their income than historical norms) was somehow never really considered. Now we're seeing mortgage debt trade at twenty cents on the dollar — tech stock-like downside — all so that in a good environment, the lender could earn 3% over safe loans. Eighty percent downside, 3% upside doesn't seem like a very good spread.

One reason adjustable rate mortgages became so popular with homebuyers and home equity borrowers was that investors were lining up to buy the debt. Adjustable rate mortgages seemed like perfect investments for Wall Street and big banks — the risk of rising rates (lenders don’t want interest rates climbing after they make a fixed rate loan) was controlled because the mortgages would reset at higher rates. Somehow, this risk (which has yet to take place, as rates are still low,) was considered much more likely than homebuyers missing payments entirely or the home falling 10-40% in value.

But the buck doesn't stop there. In recent months, all types of debt have begun falling apart. All of a sudden, investors started worrying about so-called auction rate preferreds (adjustable rate securities that closed-end funds, local governments, and other lenders use to borrow cheaply in order to make or buy additional loans), and refused to buy them, even at relatively high interest rates. If this continues, it  could lead to panic sales of the loans being made with this borrowed money.

Most recently, even the ultra-safe municipal bond market has hit the skids. We've seen Vanguard muni bond funds fall 1% to 2% in a single day. This would be relatively normal (though an far outlier, performance-wise), except for the fact that interest rates went down sharply on the days these muni bonds tanked (which would normally drive bond prices, and funds that own bonds, up). Bill Gross, who manages the Harbor Bond fund we’ve held for years in many of our portfolios, explained this situation in a TV segment. Apparently, big institutional investors and hedge funds had been buying up muni bonds because their yield was high, relative to the near U.S. government bond risk level. Of course, earning an extra 1% is only clever if you do it with tons of borrowed money...

Buying munis earlier this year was not an original idea — many financial magazines and analysts have recommended muni bonds this year for the extra yield over treasuries. Now that munis are falling on fears that bond insurers are in financial trouble, leveraged investors are panic selling after huge losses. Ordinary muni bond fund investors who bought in mid-February could be down as much as 10% (or more, in leveraged closed-end funds,) before all is said and done — stock market-grade movements for a mere 1% extra yield.

Bill Gross views this as a buying opportunity, and we agree. As investors stop reaching for yield, (and they have been unwinding these investments over the last year,) reaching for it will once again become a good idea.

We'll start getting back into higher-yield debt in most of our model portfolios, and increase those stakes if the economy and default fears begin chasing more investors out of these investments. This year might seem like a very bad time to be taking on credit risk. Of course, that's why it's a very good time, indeed.