Monday, February 11, 2013

Dangers in a Low Yield Environment

Dangers in Low Yield Environment

Have you gotten a notice from your broker that one of your bonds has matured?  When you first acquired the bond ten years ago, you thought the 4% or 5% yield was kind of paltry, but you didn’t want to take too much risk.  So you lived with the relatively low yield, and not it looks pretty good.  With the bond maturing, you are about to have a small pile of cash.  You have three choices:

  • ·      Reinvest in a similar bond, and suffer a 50% drop in your income because the new bond will yield about 2%.

  • ·      Find an investment that pays 5% in order to maintain your income (more on this option in a moment).

  • ·      Hold the investment in cash and earn 0.25% or next to nothing.

If you work with a broker, and tell him you want to maintain your income when you reinvest the proceeds from the maturing bond, he can satisfy your appetite for yield.  He can also make more money for himself, because the commission (or spread: the difference between the bid and asking price) on all the higher yielding solutions will be greater than the commission or spread on plain vanilla bonds.  Where will he steer you?

Real Estate Deal Pipeline (2006)

High yield debt can improve your yield.  However, you’ll be moving from an investment grade security, where your biggest risk is interest rates, to a junk bond security, where your biggest risk is credit.  If you invest in high yield, you need to recognize that you are no longer investing in a pure fixed income investment.  Some portion of that investment will have equity-like risk.  Institutional and retail investors alike face the yield dilemma, and have driven down yields on high yield debt, so many junk bonds don’t adequately compensate you for that latent equity-like risk.  He might steer you toward emerging market debt, in which case you can add currency and politics to your list of risks.

At least high yield’s risks are somewhat transparent.  However, your broker may reach into his bag of tricks and offer you the opportunity to invest in one or more packaged or structured products.  You should have learned from the last mass proliferation of mortgage related packaged products.  Those highly rated mortgage products were filled with hidden risks.  The new generation of products, package a variety of illiquid investments into trusts or funds.  You can have your choice of commercial real estate, commercial loans or even private equity.  The starting yields may even be higher than 4% or 5%, but the risks are many.  Unless you’re prepared to do due diligence on the underlying collateral, or employ a broker who does this kind of work, stay away from these packages.  By the way, “trust me” is not due diligence.  Moreover, you need to know that if you ever want to sell one of these products, you’re going to suffer a huge discount.

So what’s an investor to do? Acknowledging that you can’t maintain your income without taking on more risk is step one.  Understanding that doing nothing and holding cash also represents a risk is the step two.  With these preconditions in mind, you might consider a balanced approach to the reinvestment problem.  I’m going to use percentages to create a concrete example, but individual investors should make their own decisions depending on their tolerance for risk and the composition of their investment portfolio and other assets.  And for the risk takers among you, high yield or a packaged product may suit your taste.

Here’s what I have in mind.  You might reinvest 60% of the proceeds of the maturing bond in a new bond at the prevailing interest rate of about 2%.  About 20% might be invested in stocks, perhaps an ETF or mutual fund of dividend paying stocks.  True stocks represent increased risk, but at least it's a risk most of us understand.  Moreover, it is an investment with the potential to appreciate over time.  The remaining 20% would be held in cash.  Think of the cash as a reserve fund.  If you needed the yield from the maturing bond for income, you might draw down from the cash reserve to preserve your income level. If you don’t currently need the income, you might invest the cash in bonds again when yields eventually rise.  I’m not a big fan of market timing when it comes to stocks or bonds, but I’d rather take a bit of risk in waiting for yields to rise than investing in some high yield or packaged product that I don’t completely comprehend.

While low interest rate environments are good for borrowers, they are dangerous for lenders and investors.  In my view, it is better to take a balanced approach with the basic building blocks of investing than to reach for esoteric solutions.

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