Stock Market and Investment Losses and Investing and Opinion and Investing Column and Wealth Management

SKARBECK: Reaching too far for yields may have consequences

March 5, 2011

Ken Skarbeck InvestingThe 2010 Berkshire Hathaway annual letter was released Feb. 26 and, as always, is worth a comprehensive read.

New and seasoned investors seeking a rational way to “think about investing”—a trait Warren Buffett calls investor “temperament”—can get a tremendous business education reading the Berkshire annual letters and watching, for example, the recent outstanding three-hour question-and-answer interview of Buffett on CNBC, along with attending the occasional Berkshire Hathaway annual meeting in Omaha, Neb.

In the letter under the subtitle “Life and Debt,” Buffett discusses the dangers of leverage (borrowed money) and why Berkshire will always hold a significant cash cushion. He tells us that most of Berkshire’s cash is invested in U.S. Treasury bills and not in any short-term securities yielding a little more.

Buffett then quips: “We agree with investment writer Ray DeVoe’s observation, ‘More money has been lost reaching for yield than at the point of a gun.’”

Investors eager to capture return are frequently attracted to investments that offer high yields. But before leaping into them, they should remember the useful idiom: “There is no free lunch.” On balance, a higher yield implies higher risk among similar investment alternatives.

Investors in auction-rate securities found this out during the credit crisis. Long-term fixed-income securities were fabricated into securities that appeared to have shorter-term maturities with higher yields. When the credit markets froze in 2008, auction-rate securities became illiquid investments. There is still $130 billion in auction-rate securities stranded in investor accounts.

Certain money-market funds and short-term bond funds were tested during the Great Recession. Charles Schwab recently settled an SEC lawsuit for $119 million over its YieldPlus Fund, which was marketed as a safe, ultra-short bond fund and a money-market alternative. The fund had $13.5 billion in assets, but suffered a negative 40-percent total return in 2008 and 2009 because it invested nearly half its assets in mortgage-backed securities.

Another hot seller in recent years has been market-linked CDs, which are certificates of deposit linked to capture a portion of the return on a stock market, commodity or currency index. These “structured products” are created with derivatives and carry high fees ranging from 1 percent to 3 percent. In 2009, Wells Fargo sold $5 billion worth, with one commentator noting they are “a great selling tool to nervous nellies.” It is important that the investor understands the terms on these products. For example, an untimely drop in the stock market near maturity could hurt the overall return. Also, most market-linked CDs don’t pay off until maturity, yet taxes are due on the implied interest income each year.

Oil royalty trusts have been popular with investors attracted to their high distribution yields. These companies are structured as master partnerships that pay out all their income from operations. The payouts flow through to the investor often on a tax-advantaged basis due to depreciation and depletion. Investors in royalty trusts must understand that the distributions can vary significantly depending on the price of oil and the rate at which the property depletes its oil.

Seeking high yields has always been a quest for investors. In most cases, to obtain a higher yield, the investor must travel farther on the risk spectrum.•

__________

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

ADVERTISEMENT

Recent Articles by Ken Skarbeck

Comments powered by Disqus