Andrew Silton: High-yield, fixed-income investments carry risks

For the past five years, American investors have lamented the paltry yields on U.S. Treasury bonds and other investment grade bonds. In order to help repair the grave damage brought on by the credit bubble, the Federal Reserve has held short-term interest rates at near zero. While low interest rates have been helpful to big businesses and hedge fund managers seeking to borrow money, it’s been a big problem for savers.

Even today with the U.S. economy in a sustained recovery, an investment in the five-year U.S. Treasury bill only yields 1.5 percent. However, that yield looks pretty attractive in comparison to the equivalent government bond issued by Germany or Switzerland. In Germany and Switzerland, the five-year government bond yields are -0.09 percent, and -0.42 percent.

That’s not a typographical error. If you invest in one of these government bonds, you owe a small amount of interest to the lender. In an effort to defend their economies and weaken their currencies, Germany and Switzerland actually charge investors for the privilege of lending money. For example, if you buy 1,000 francs ($1,045) worth of five-year Swiss government bonds, instead of receiving an interest payment, you owe the government 4.2 francs ($4.39) each year. In short, you are guaranteed to lose a small amount of money in exchange for investing in the safety of Switzerland or Germany.

Those of us trying to balance the risk of our equity investment with the relative stability of fixed income are left with a dilemma. While most of us have little interest in German or Swiss bonds, we’re forced to accept incredibly low yields if we want to stick with high-quality American fixed income investments. Whether we’re talking about municipal or investment-grade corporate bonds, yields are low. Even if we are willing to invest in longer-term fixed income such as 10-year bonds, the yields are pretty paltry for someone trying to generate income. A 10-year AA-rated corporate treasury or muni only yields about 2.8 percent and 2.3 percent respectively. These low yields have had particularly difficult consequences for retirees, who are mainly interested in generating income from their savings.

Understandably and in the long run regrettably, both institutional and retail investors have decided to chase higher yields by adding significantly more risk to their investment portfolios. In the past five years, Wall Street has created and promoted all sorts of mutual funds and exchange-traded funds dedicated to generating higher yields, which now represent over $700 billion in assets. I can’t begin to describe all the categories now available to investors. However, the main mutual fund and ETF options are high-yield corporate or municipal bonds, emerging market debt, and portfolios of relatively low quality asset-backed securities.

Companies that have borrowed heavily to finance private equity deals or a flurry of acquisitions often issue high-yield bonds. High-yield municipal bonds are issued by states or subdivisions of states that have also borrowed heavily or face serious financial problems, like grossly underfunded pension plans or weak tax bases. Governments and companies in places like Brazil, India, China, and Russia issue emerging market debt. Asset-backed securities are investments funded by mortgages, student loans, credit cards or auto loans. While some asset-backed securities are of high quality and therefore low yield, Wall Street has also put together investments backed by mortgages or loans of individuals with poor credit histories.

In each of these categories, investors have been tempted by higher yields. After all, who wouldn’t want to earn 5 to 10 percent from fixed-income investments when investment-grade mutual funds or ETFs only earn 1 to 3 percent? However, those enticing yields aren’t free. Investors face a significantly higher risk of default from these types of investments. Over an economic cycle enough highly leveraged companies and consumers are going to default so that the promised 5 to 10 percent yield will fail to materialize. In addition, foreign bonds carry both political and currency risks, which we’ve seen manifested in Russia, Brazil and Argentina. Overall, the demand for these types of investments has been so great that the yields on these risky fixed-income investments are far too low to compensate investors for the risk they are taking. Nonetheless, the temptation is great in a world where U.S. Treasuries pay little interest and German and Swiss bonds charge for the privilege of investing.

It has never been easier to participate in higher-yielding securities thanks to mutual funds and ETFs. However, it may not be so easy to get out of those investments. In its latest report to Congress, the Federal Reserve notes that investments in these riskier areas of fixed income are at higher levels than before the credit crisis and pose a risk beyond the common ones of default, inflation, currency, or politics. According to the Federal Reserve, these types of higher yielding mutual funds and ETFs pose liquidity risk.

To illustrate the point, let’s focus on the iShares emerging market bond ETF (NYSE: EMB), a sizable fund with $4.4 billion in assets. Whether you use a broker or do it yourself, it is easy to buy 200 shares of EMB. However, it may not be so easy to sell the fund if (when) there’s a crisis. These types of ETFs or mutual funds aren’t investing in liquid securities. Rather, EMB is investing in relatively illiquid bonds such as those of the Russian Federation, Polish Republic, Republic of Argentina, and Petronas Capital (Malaysian Energy Co.). Moreover, many of the other emerging market bond ETFs and mutual funds are invested in the same securities. These bonds don’t trade on an exchange or in huge volumes, so when investors decide en masse to sell shares in the ETF, prices may take a particularly steep stumble because the ETF trustee suddenly has to sell a large number of distressed bonds in a market with few takers.

Even more worrying, many retail investors or their advisers are actively trading higher yielding ETFs. It’s one thing to make short-term bets in highly liquid markets like large cap ETFs, but ETFs backed by bonds are another matter. Even on a good day, when there are few hints of crisis, bond ETFs tend to trade with between 5 and 25 percent of the volume of equity ETFs. There’s much less liquidity. Nonetheless, investors are using ETFs to speculate on the possibility of bankruptcy in Puerto Rico, the direction of the Russian ruble, or the default rate on used-automobile loans. This is a game that may leave long-term investors like you and me a lot poorer and very uncomfortable during the next financial crisis.

The search for yield has also distorted many investors’ asset allocations. Many of you have probably had a lengthy discussion with an adviser or filled out a detailed questionnaire in order to determine your investment objective and appetite for risk. Through that process, you’ve figured out how much of your assets should be devoted to stocks, bonds, and perhaps real estate. However, if you have loaded up on high yield and emerging market mutual funds or ETFs, you are taking far more risk than your asset allocation would suggest. If you’ve devoted 5 or 10 percent of your assets to high yield funds, you probably don’t have much to worry about. However, if your portfolio has 20 to 30 percent of your assets invested in emerging market debt and/or high yield bonds, you might want to revisit your asset allocation, because you’re taking more risk than you bargained for.

The low interest rate environment engineered by the Federal Reserve and other central banks can be a very dangerous one for investors. While the primary goal of low interest rates is to stimulate the economy, the side effects can be toxic. Although many of us understand the risks of investing in stocks, we don’t fully appreciate the risks of investing in high-yield fixed income. Nonetheless, those higher yields are tempting, so we’re lured into shifting our portfolio from safer to riskier fixed-income investments. This is especially the case because mutual funds and ETFs make it so easy. In investing, doing what’s easy is often a mistake.