Margin-of-Safety

Speculators and Unsuccessful Investors 28
among Wall Streeters as "yield pigs" (or a number of more derisive names), such individual and
institutional investors were susceptible to any investment product that promised a high rate of
return. Wall Street responded with gusto, as Wall Street tends to do when there are fees to earn,
creating a variety of instruments that promised high current yields.
U.S. government securities are generally regarded as "risk-free" investments, at least
insofar as credit quality is concerned. To achieve current cash yields appreciably above those available
from U.S. government securities, investors must either risk the loss of principal or incur its
certain depletion. Low-grade Securities, such as junk bonds, offer higher yields than government
bonds but at the risk of principal loss. Junk-bond mutual funds were marketed to investors in the
1980s primarily through the promise of high current yield. As with a magician performing sleight
of hand, investors' eyes were focused almost exclusively on the attractive current yield, while the
high principal I risk from defaults was hidden from view.
Junk bonds were not the only slop served up to the yield pigs of the 1980s. Wall Street
found many ways to offer investors an enhanced current yield by incorporating a return of the
investors' principal into the reported yield. "Ginnie Maes," which are, in fact, high-grade securities,
are one such example. These are pools of mortgages insured by the Government National
Mortgage Association (GNMA, whence Ginnie Mae), a US. government agency. GNMA pools
collect mortgage interest and principal payments from homeowners and distribute them to
bondholders. Every month owners of GNMAs receive distributions that include both interest
income and small principal repayments. The principal portion includes contractual payments as
well as voluntary prepayments. Many holders tend to think of the yield on GNMAs in terms of the
total monthly distribution received. The true economic yield is, in fact, only the
interest payments received divided by the outstanding principal balance. The principal component
of the monthly distributions is not a yield on capital, but a return of capital. Thus investors who
spend the entire cash flow are eating into their seed corn.
The same principle is operative in option-income mutual