Monday, March 12, 2012

Chasing Yield? Buyer Beware!

Are you or the advisor that works for you, using bonds to stabilize your portfolio throughout retirement?  That is the ultimate goal.  However, if you think all bonds are created equal then you may get caught on the wrong end of the yield curve.  If this happens then a whole new generation of individual investors will find out that their pretty little asset mix designed to reduce volatility, actually may become very volatile.
The problem I see is the mad rush into long-term bond mutual funds as individual investors are hungry for yield and chasing returns.  The sophisticated investor, I am quite confident, will be able to take advantage of rates at zero and will be smart enough to lock in gains at some point in the future.  However, the majority of individual investors and advisors are not sophisticated, and they are using these types of funds as a long-term solution to provide stability in their asset allocation models.  I suggest they take a look at the not-so-distant past and see how this mix worked out in the “risk off” environment of 2008.
Many individual investors do not understand interest rate risk and the potential negative impact it may have on the bond side of their investment equation.  With interest rates at zero it does not take much insight to realize that at some point, rising interest rates will send long-term bond prices down.  It is just a matter of "when" rather than "if".  This rise in interest rates could come from an explosion in inflation, which is not good for anyone, or from strong economic growth over the next few years.
Understanding what type of bonds you own is essential, especially for retired investors.  When I am designing tactical allocation strategies, I consider the bond side of the equation sacred.  That is the part of the portfolio that I am relying on for price stability and to help drive down the overall beta (risk) of a portfolio when compared to the equity markets.  Investors need to understand that if they own a long-term corporate bond fund or a municipal bond fund, and today are enjoying the higher yield, that these fund managers are mandated to own these types of bonds.  There is very little room to maneuver and these fund managers need to remain fully invested at all times.  You need not look any further than 2008 to see what this could mean for these types of bond funds.  2008 was an example of what we like to call "risk off".  Anything that did not provide a guarantee experienced a vicious downturn.  If you are using an asset allocation mix to provide stability, then it is essential to hire a fixed income manager that takes a "total return" approach.  These types of managers have a tremendous amount of flexibility.  They not only have the ability to move to a large cash position when they see risk on the horizon, but they also have the ability to own any type of fixed income instrument that they feel could provide the highest total return.  Sometimes that means the best total return may be no return versus losing 25% of the portfolio's value.
The fact that interest rates are at zero obviously scares me.  However, the fact that long-term bond prices have been sent artificially higher by the Fed's latest quantitative easing program (QE3) scares me even more.  Due to the fact that interest could not be lowered any further it has led the Fed to come up with new and creative ways to try and stimulate the economy.  The Fed’s newest approach is being referred to as “Operation Twist”.  What is Operation Twist? Basically the Fed can’t reduce short-term interest rates any further because they’re already at zero.  Therefore, the Fed wants to reduce long-term interest rates instead.  They do this by selling short-term bonds and using the proceeds to buy long-term bonds.  When you buy more of something, you raise the price.  When you raise the price of a bond, you lower the interest rate.  So what the Fed is doing is artificially lowering long-term interest rates. 
What will happen to long-term rates when the Fed is done with its easing program?  If QE3 does its job, and the economy continues to improve, then this will be great for equities.  However, it will also allow the Fed to gradually release their stranglehold on interest rates.  Long-term rates will then be allowed to rise, and this will have a negative impact on long-term bond prices.
The other concern economists have with all three of the Fed’s quantitative easing programs is the negative impact that they may have on the US dollar and many believe the programs will send commodity prices higher.  I do not know if they are correct, but we have certainly seen a reaction in oil prices since the announcement of QE3.  If massive inflation is an end result to the easing programs, then the only weapon the Fed has to offset inflation would be to aggressively raise interest rates.  Which would be another negative for long-term bonds.
What other reaction did we see when the Fed announced its QE3 program?  Immediately after the announcement a huge amount of institutional money funneled into Treasury Inflation Protected Bonds (TIPS).  Think about that for a second.  Immediately after the announcement of QE3, the smart money chose to move into a negative yielding TIP, while individual investors moved more into long-term bond funds.
Retired investors must learn to use the bond side of their investment mix as a measure of safety, and should stop chasing yield and capital appreciation without understanding the principal risk they are assuming.  High yielding closed-end funds that use leverage to stabilize their net asset values, and long-term bonds are all facing interest rate risk in the coming years.  If stability is your goal, then you must use a total return approach to owning bonds.
Thank you and good luck everyone!
Jon R. Orcutt, founder of Allocation For Life, is an asset allocation strategist and author of “Master the Markets with Mutual Funds: A Common Sense Guide To Investing Success”

*** Added note.  I am aware that Operation Twist is not QE3.  But let's call it what is, and that is manufactured artificial easing.