Often times here at Macrowealthpreservation, I post updates on factors effecting gold because I believe that its one of the few places where, in this environment, wealth can be both preserved and even grown given the government controlled markets we have experienced since 2008. Today however, I just want to point out the dangers of chasing yield, especially in the area of high yield or "junk" bonds.
The Fed's ZIRP (zero interest rate policy) have lowered interest rates to levels few professionals ever thought possible. This has resulted in savers seeing little opportunity to earn interest in savings accounts, money markets, CD's, or relatively safe bond funds. Indeed, many of these pay essentially zero and substantially less than the real rate of inflation. Even when compared to the government's CPI, which massively under reports the real inflation level people experience, savers using conservative instruments that I mentioned above are actually losing purchasing power. The Bureau of Labor Statistics reported recently in October that the CPI for the previous 12 months was a well controlled 2.2%. If you are getting even 1% from a CD (you can check rates at bankrate.com) you are at a loss when you minus out the 2.2% of CPI. Its much worse if you follow Shadowstats and see that its more like 10% when calculated in the 1980 based method.
The result of this has been for yield hungry investors to pile into bonds, and more specifically into high yield bonds. These are bonds of companies that either are not well established or do not have the credit ratings to be considered "investment grade". A higher yield is paid on these bonds than investment grade, but don't forget, risk and reward are highly correlated. With the greater yield comes greater risk associated with them and a higher default rate especially when the economy turns down (as it very well may be doing right now). In addition, with the high demand for these bonds comes higher bond prices and lower yields (bond prices and yields move in the opposite direction). HYF is an exchange traded fund (ETF) that holds high yield bonds. A few years back it had a yield of 10%, a near equity like return. Today because of the high demand the yield is 8% but they are just as risky (or more so if the economy is slowing).
Don't get me wrong, investing in high yield can be a great investment for the right person at the right time. For example, I enjoyed large double digit returns in 2002 investing in these types of bonds as the economic recovery got underway and over a 50% return starting in 2009 over an 18 month period. But high yield can also cause double digit losses, especially as the economy is turning down. High yield is sensitive to both interest rates like other bonds, but also to earnings like stocks. This means that high yield bonds are more sensitive to the economy. They'll be one of the first assets to decline when the economy is waning, as many investors may well lean soon.
CNBC actually has a decent and timely article on this.
The money manager's job is supposed to be straightforward: Take people's cash and put it to work. The more money that comes in, the bigger the manager's paycheck.
So why would two of the country's largest fund managers tell would-be investors in junk bonds—the common name for bonds issued by companies with the lowest credit ratings—to go away?
The short answer is that it's for their own good. The market for junk bonds, the pros say, has become so popular that it's dangerous.
Thanks largely to the unsteady economy, interest rates on U.S. government bonds have fallen to record lows. And individual investors remain leery of the stock market.
Desperate for better returns, they're sinking billions into higher-paying bonds backed by businesses with bad credit scores. Those deeply indebted companies have borrowed a record amount from investors and are increasingly using the money in ways that could strain their ability to pay it back.
Earlier this year, two mutual fund giants, T. Rowe Price and Vanguard, began turning down people hoping to invest in funds that buy junk bonds. Both said they were running out of worthwhile places to put customer money.
"It's getting harder and harder to find places to invest," says Michael Gitlin, director of fixed-income at T. Rowe Price. He says investors are getting paid record-low interest rates for taking on much more risk.
Consider the numbers:
All that money has started to change things. For a while, falling borrowing costs and willing lenders prevented many troubled companies from sinking into bankruptcy.
- Junk-bond sales in the U.S. snapped the single-year record in October and have kept climbing. Sales for the year totaled $324 billion as of Nov. 28, according to Dealogic, a data provider. In the three years leading up to the 2008 financial crisis, a time marked by easy lending, companies with junk credit ratings sold an average of $144 billion each year.
- Companies are lining up to sell bonds because borrowing rates have never been lower. The typical company rated "speculative-grade," one of the polite names for junk, pays 6.6 percent to borrow in the bond market. The average over the past decade was 9.2 percent, according to T. Rowe Price research.
- Demand for junk has remained strong. Individual investors, people saving for retirement or building a nest egg, have put $28 billion into U.S. junk bond funds this year while pulling $85 billion from U.S. stock funds, according to Morningstar.
- Over the past 10 years, individual investors have dropped $96 billion into the junk bond market, according to a Vanguard research paper. The bulk of it, 77 percent, was deposited in the past three years.
But what's good for borrowers can eventually be dangerous to investors. Fund managers and analysts now warn that the seemingly boundless appetite for bonds has eroded lending standards. Companies with shaky credit scores can borrow on easier terms for questionable purposes.
Few have run into trouble so far. Over the past year, just 2.8 percent of low-rated companies have missed an interest payment and defaulted, according to Standard & Poor's. That's roughly half the long-term average.
Dig deeper and the numbers don't look as encouraging. For corporate borrowers with the worst ratings, the same ones taking up a larger share of the market, the figure is 27 percent.
Gitlin and others say recent trends remind them of the easy-lending era before the financial crisis, when Wall Street and bond traders treated caution as a sign of weakness.
"When you start seeing things like you saw in '06 and '07, you should be concerned," Gitlin says.
Over recent months, more than a third of the money raised in the market has gone to corporate borrowers that credit rating agencies consider likely candidates for bankruptcy, those with the lowest of the low credit scores, according to S&P.
Where the money winds up has changed, too. Some of it simply fuels deal-making by private equity firms, investment groups like Bain Capital and The Carlyle Group that buy and sell businesses. In these leveraged buyouts, a private equity firm borrows money to buy a company, then saddles it with the debt.
More of these private-equity firms find they can dip into the bond market to reward themselves. In these "dividend deals," a company sells bonds and gives the proceeds to the owners, even though the company has to cover the debt.
In one recent deal flagged by the rating agency Moody's Investors Service, the management consulting firm Booz Allen Hamilton raised $1 billion to pay a dividend to The Carlyle Group and other firms.
"Private equity firms are basically saying, 'Hey, if you want to give us your money at record low rates, we'll take it," says Kingman Penniman, founder of KDP Investment Advisors.
Yet another alarming trend is the reappearance of bonds that allow corporate borrowers to switch off their interest payments. They're known as "PIK toggles," because the issuers can toggle off their regular payments and "pay in kind" with IOUs. Investors who bought them during the mid-2000s credit bubble got burned.
"You'd think, 'We'll never let issuers get away with that again. PIK toggles are dead,'" Gitlin says. But fund managers have to put investors' money somewhere, Gitlin says, so they wind up holding their noses and buying against their better judgment.
What bothers Chris Philips, a senior analyst in Vanguard's investment strategy group, is that so many people have trusted their savings to bond funds because they're not considered as dangerous as stocks: Buy a bond, and as long as the country, state or company behind it stays in business, you can expect to get your money back.
It's a different story for people who invest in a bond mutual fund. The fund's price rises and falls to reflect the total market value of the scores of bonds within it.
Junk bonds backed by companies with the worst credit can be just as risky as stocks, Philips says. Unlike other types of fixed-income investments, the junk market is prone to big price swings when traders get nervous. At the depths of the 2008 financial crisis, an overall market index sank from around 90 cents on the dollar to 55 cents.
"That's a big hit," Philips says. "I think the average person's association with bonds is that they should be safer than stocks."
All it will take, Phillips and others say, is a dust-up in Washington over avoiding the tax hikes and government spending cuts known as the "fiscal cliff" to cause a sharp drop in the stock market. If that happens, the junk-bond market will likely take a fall.
And then, Gitlin says, a lot of new bond investors will be calling up their fund managers to ask: "How can you lose money in a bond fund?"