The old adage “Better safe than sorry” always returns to popularity after financial collapses, mainly because many people are “sorry.”
Because it has been more than five years since the last financial calamity and it feels like the distant past, many investors are now ignoring this advice. So it appears apropos that we have this discussion now rather than moaning after the next market downdraft.
Mind you, I am not predicting when the next such correction will occur, and, as regular readers of this column know, my call on the underlying strength of the U.S. economy has been spot-on. However, it would be appropriate, while markets are high, for the readers of this column to at least take stock of the risk/reward ratio in their investment portfolios.
Most of the population, if they even have retirement savings, have 401(k)s and IRAs where there is no guarantee as to the value of the account at the employee’s retirement date. Yet, because it is a major contributor to the retirement plan, it is very important to each retiree that this part of his or her retirement plan reach its contemplated goal.
Readers with 401(k)s or IRAs should ask themselves how confident they are that their investments are 1) safe and 2) will produce consistent returns that will grow to meet their retirement needs.
For those closing in on retirement, safety is of utmost importance. They should ask what would happen to their account values if the equity market or the bond market (or both) had another major “correction.”
Do they have enough years to retirement to wait for markets and their portfolios to recover (at least five years, sometimes more)?
The basic issue here is the tradeoff between risk and return. Over the past five years, the Fed has had a “Zero Interest Rate Policy” (ZIRP) and there have been two consequences for retirement investors: 1) It is nearly impossible for them to obtain the yield needed to safely achieve their retirement; 2) To compensate for this, investors take on inappropriate risks.
As a result of five years of ZIRP, investors are now stretching for yield and ignoring risk. Fed Chairwoman Janet Yellen even commented on this in her testimony to Congress in May.
Because of the historically low cost of funding for the past five years, even high-risk companies have been able to borrow cheaply. As a result, financially weak companies can continue in business as long as their cash is adequate to meet current liabilities, even if they are technically insolvent (liabilities greater than assets).
In the equity markets, utilities have been among the top performing sectors for quite some time because they pay high dividends. These are capital intensive businesses and must continuously and heavily invest in infrastructure, which is expensive to build and maintain. What will happen to their funding costs, their dividends, and their stock prices when ZIRP is no more and interest rates rise?
But there is no better example of investors stretching for yield and ignoring risk than the high yield bond market.
“High yield” is really the PC term for “junk” bonds; they are junk because their credit ratings are “below investment grade.” They have ratings from BB+ to C. As discussed above, for the past five years, lower-rated companies have had low default rates.
Nevertheless, retirement investors should not ignore the historic default rates on these junk bonds. From 1981-2008, here is the annual average defaults by rating: BB = 0.9 percent; BB- = 1.5 percent; B+ = 2.4 percent; B = 7.3 percent; B- = 10 percent; CCC to C = 22.7 percent.
Reversion to the mean
One of the basic tenets of financial markets is the concept of “reversion to the mean.” So it is likely that, while today’s default rates are low because of ZIRP, they will revert to their means, most often swinging past those means as they move in the opposite direction.
For example, while B-rated bonds defaulted at a rate of 7.3 percent from 1981-2008, between 1990 and 1992, their default rate was 14.5 percent, and between 1999 and 2002, it was 11.6 percent.
As is evident from such default rates, junk bonds or a junk bond fund that returns 5 percent-6 percent per year is not compensating investors for the underlying credit risk.
In fact, the “real” long-term yield might even be significantly negative. (And I am only talking about credit risk here — interest rate risk, the price correction that occurs when rates rise, is also huge for these junk bonds.) This kind of risk does not belong in a retirement portfolio, especially one where retirement is being contemplated.
As I said at the top, it is better to have this discussion now while markets are high, than to have it after a major correction. Sooner or later, the Fed will have to end ZIRP. Yellen and the Fed’s talking heads make it sound like the end of ZIRP is still years away, and it might be. But when unexpected events occur, markets move rapidly, especially a market that is priced for perfection.
Think about what happened to the bond market last summer when then- Fed chief Bernanke uttered the unexpected “taper” word (a 1 percentage point backup in the 10-year Treasury yield and in mortgage rates in a very short period of time). Sooner or later, ZIRP is going to end. When it does, risky investments will pay the price.
Better safe than sorry! As famous Wall Street economist David Rosenberg would say, “Forewarned is forearmed!”
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. Robert is available to discuss client investment needs. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.