With interest rates low – the Federal Reserve intends to raise short-term ones, but only slowly – bond investors don’t get much return and won’t for some time. That entices them into reaching for yield in questionable places, much like people who eat fast food, full of calories, fat and sugar.
Desperate times can lead to desperate measures. For example, food is necessary for survival and when food is scarce, people will consume some pretty unappetizing stuff.
The food choices we make often show up in shrinking or expanding waistlines, but sometimes the effects aren’t so visible; such as high blood pressure or fluctuating blood sugar levels. Not eating isn’t a long-term option. We must eat to live and the same applies to funding retirement.
The nutrition required to fuel retirement is income. It can be fun to talk about assets amassed, but you can't eat gold, silver, houses or even stock certificates. After retirement, investors still need buy food as well as other necessary and discretionary purchases. Traditional dishes for fueling retirement include banks’ fixed rate certificates of deposit (CDs) and stock dividends.
But things change. Following the economic collapse of 2008, the interest rate environment has remained dismal. In response to the Great Recession (I still feel historians will eventually call it our generation’s Great Depression), the Federal Reserve lowered bank interest rates in a full assault on declining asset prices.
Bond rates joined the crowd, and suddenly individuals living on fixed incomes started getting hungry. In many cases, their income streams were cut by more than half – a crash diet for their investment streams.
At first, consumers simply tightened their belts, spending less while waiting for rosier rates to prevail. Their mantra was, “this too shall pass,” and they expected rates to return to the customary 4% to 5% range – except rates haven’t returned to such levels. Hope is never a good strategy.
Somewhat comparable to the 1850s Irish potato famine, today’s investors are remiss to eat the seeds, or the principal, in their accounts. So they search out better options.
After an extended period of low rates, some investors have stopped investing in higher quality assets and started lending to less creditworthy sources – like junk bonds, which pay higher interest rates.
According to the FINRA-BLP Index, junk yields are rising and now average 7.5% yearly, which is far above a 10-year Treasury, which is just over 2%. Moody’s Investors Service expects U.S. junk defaults to rise to 3% of total high-yield bonds by year-end from 2.3% of in the second quarter. While 3% isn’t high historically, the trend is not encouraging.
As compensation for assuming a greater risk of default, these investors expect higher income streams. As long as the strategy works, it doesn’t seem particularly horrific. Income streams have risen, for now.
Just like a teenager subsisting on a diet of pop and candy, the effects of junk food investing will also eventually show up. Appetites for more robust income streams have moved many income-searching investors into portfolios of fixed income products they may not fully understand. Assessing and addressing risk in a bond portfolio is just as important as knowing the types and composition of stocks held.
As the Federal Reserve contemplates raising rates, the sagas of Greece, Puerto Rico and Detroit’s economies continue. All three are mired in debt. And the effects of billions in energy company debt (in 2015, this is the worst-performing U.S. stock sector, other than utilities) will be bad for many investors.
Balancing fixed income, reasonable returns and reasonable risk becomes increasingly difficult. Investors need to know what they own and what risk they are willing to digest.
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Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He is the host of Consider This with Big Joe Clark, found on WQME and iTunes. Big Joe can be reached at [email protected], or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.
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