Chasing Risky Bonds Can Be Hazardous To Your Health

Money chasing income. That is a theme we have discussed much recently as an ageing population battles an artificially low interest rate environment. The demand for income is driven by an undersaved population rapidly approaching retirement. They have seen years of savings wiped out by two nasty bear markets since the turn of the century and are now plowing money into income producing assets at a rapid pace.    

Since the beginning of 2009 individuals have withdrawn more than $202 Billion from equity mutual funds.  However, during that same period inflows into bonds funds swelled more than $1.5 Trillon.  The question is whether these individuals are again making the same mistakes of the past?  Chasing performance, with little regard to the unintended consequences of markets driven by artificial influences, has not turned out well previously.

Lance Roberts

During the 2004-2007 bull market cycle investors chased equities, commodities and emerging markets investments as the housing and credit expansions fuelled the artificial wealth effect.  As the credit bubble crested investors clung to their investments as market analysts and economists were proclaiming that things were “contained.”  They were not – and the damage to retirements, and individual’s lives, was devastating.

Since then these investors have shifted their mentality from chasing equities to finding yield from stocks and bonds.  Bob Farrell once stated that “investor’s buy the most at the top and the least at the bottoms”  meaning that individual investors tend to react emotionally chasing the best performing assets right into the bust.  The chart shows the BofA Merrill High Yield Index.

Lance Roberts

First of all, it is critically important to understand that “high yield” is jargon for “junk bonds.”  In other words, “high yield bond funds”, which is a great marketing moniker for the uninitiated, means that the fund owns the debt of companies that are less than credit worthy.  These companies are much like your cousin who asks to borrow money from you, and promises to pay you back, with a high rate of interest.  The problem is that he has a very spotty employment record, does not manage his finances well, and has no money currently to his name.  Do you lend him your money?  However, this is exactly what investors have been doing in droves over the last three years.  

The problem is that this does not typically work out well.  The next chart shows the spreads between the AAA-rated 10-year treasury and BB rated corporate bonds (BB is the best of the junk bonds – uhh, I meant, high yield bonds) as well as the S&P AAA-rated bonds and BB rated bonds.  

Lance Roberts

Importantly is that historically, when yield spreads are at current levels, it has been indicative of economic problems.  When the economy stumbles – these “high yield” bond issuers tend to go bankrupt at an alarming rate.  The Fed’s intervention with QE 2 in 2010 is credited with keeping the economy from sliding into recession.  The question is will QE 3 have the same effect?  Investors are currently “all in” betting on QE 3 pushing spreads to levels that are historically alarming.

Investor’s have also been chasing stocks with the highest dividend yields in their quest to increase income.  The number of companies that now pay a dividend is 402 which is a level that has not existed in 13 years.  More than 70% of those companies, which have already been paying a dividend, have boosted it within the last twelve months as uses for cash stockpiles are limited due the sluggish economy.  That is the good news.  The bad news is that investors have been piling into these same companies pushing valuations well beyond normal ranges.  The chart shows two things: 1) rising dividend yields are associated with negative annualized returns in the S&P 500 and 2) the spread between the 10-year treasury rate and dividend yield is currently at levels associated with negative market returns.  This is a warning – not a prediction.

Lance Roberts

The problem for those heading into, or in, retirement is the quest for income and safety.  After the last decade the “return OF capital” has become much more important than the “return ON capital.”  With a sluggish economy affecting wage income, interest rates at historically low levels, and current standard of living costs on the rise – investors have been systematically pushed into chasing yield.  The continued artificial supports and interventions by Central Banks, both domestically and globally, have led to a false sense of security that markets will continue to travel upwardly, and “high yield” bonds will continue to pay, indefinitely into the future.  That event is as unlikely as subprime loans being “contained.”

It is important to understand that I am not saying that a recession or market crash is about to happen.  The markets, especially when running on “hope”, can remain elevated for far longer than logic would dictate.  However, reversals in the economy, and the markets, come very quickly and will blind side investors lulled into a false sense of security.  Will you be paying attention?

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