Yes, it is true that it can be prudent not to bet against the Fed. However, the operative word here is “bet.” Bet equals speculation. Speculation means that you are hoping to buy low and sell high or short-sell high and cover buy low. Anyone who invests in an asset or assets with values being boosted by Fed policies (which by the way are always temporary) and convinces themselves or allows themselves to become convinced that Fed policy will always come to their rescues deserves what they get when the Fed acts for the greater good of the economy and financial system in a manner which is not beneficial for your investments.
To see a list of high yielding CDs go here.
During the 1990s and early 2000s, there existed what came to be called the “Greenspan Put.” The Greenspan Put theory was as follows: “As soon as the economy slowed and the equity markets became troubles, then Fed Chairman, Alan Greenspan, would introduce accommodative monetary policy. Asset values would soon increase on the back of low rates and the resulting pickup in growth. This lulled investors into a falser sense of security. Many investors, including professional investors thought it was acceptable to take on significant amounts of risk because the Fed would ease at the drop of a hat. The result would be more risk taking which would then support and/or lift asset prices (including prices of high-risk assets).
Many investors and market participants believed this “put” would be in place during the tech bubble in the late 1990s. In spite of the fact that many “dot-coms had no business plans, no profits and, in some cases, little revenue, money continued to pour into almost any web-related venture. This happened even though Mr. Greenspan warned of irrational exuberance for the first time on December 5th, 1996. Following Mr. Greenspan’s comments, global equity markets slumped. However, when the crises in Asia and Russia threatened the economy and markets, The Fed eased monetary policy. This reinforced the belief that the Greenspan-led Fed was there to put a bottom under asset prices. However, by June 1999, when the tech bubble resembled a certain character from the Austin Powers movies, the Fed began tightening, moving the Fed Funds rate from 4.75% in May 1999 to a cyclical peak of 6.50% in May 2000. The Fed kept the Fed Funds rate at 6.50% until January 2001 when the Fed began easing. To this day, many critics blame the Fed for bursting the tech bubble. Truthfully, it was the fact that many of these tech startups were never viable entities to begin with. If the Fed left policy accommodative for a longer period of time, the bubble would have likely grown larger and the explosion more forceful when it eventually exploded.
The Housing Bubble illustrates what can happen when policy becomes too accommodative for an extended period of time. Moral hazard of Fed accommodation desensitizes investors to risk. We believe that this is happening at the present time.
We cannot count the number of times we have been solicited by mutual fund wholesalers hawking their latest and greatest product. They proceed to tell us how well loans have down thus far, thanks to Fed policy, and how an accommodative Fed and more robust growth have made CCC-rated loans less risky than to what their credit ratings might indicate. Please, asset values which live by Fed policy tend to die by Fed policy. The following is an actual response to a marketing e-mail sent to me (on a personal basis) by a loan fund wholesaler:
“I think loans have run their course. Fed policy has pushed more capital than what should be there for fundamental reasons. Loans CAN perform fairly well in a rising rate environment when the Fed is raising the Fed Fund Rate to slow a rapidly expanding economy. This is not the case this time around. Longer-term rates are in the process of resetting, but short-term rates (including LIBOR which is joined at the hip with Fed Funds, no more than ever) will remain unchanged until at least 2015 if not 2016. By 2016, junk loan borrowers will be faced with higher rates and investors will be able to get attractive returns with higher-rated debt. Cov-lite loans could be a problem and I see them in Loan funds. Lastly, when investing in debt, I always want a maturity. I want to know that par is, if not a certainty, at least a reasonable possibility. I am a bond trader with 23 years of fixed income experience. Returns from FI will be mostly from coupon income, not from asset price valuations. I would rather build a ladder (not necessarily evenly weighted, take my 3.50% and sleep at night.”
“If I could cherry pick my own loans and would be able to hold them to maturity, I might be interested for speculative clients. However, with many loans, there will be no floating now and when they do float in three years, the higher coupon is going to weigh heavily on some borrowers, just like mortgage borrowers who cannot pay their floating rate mortgage and cannot refi into an affordable fixed rate loan, if they can refi at all.”
“If I could by loans issued prior to 2011 with ratings of B or above and I can own the actual loan, I would consider it. Otherwise, I will pass.”
Investors need to understand how various fixed income vehicles work and know why they choose to own them. We hear sales pitches regarding junk bonds and junk bond funds. It is the same old story: “Junk debt tends to decouple from rising rates.” That can be true, when rates are rising because the Fed is tightening to manage inflation pressures. This is not the case at the present time. Long-term rates are “resetting,” more or less reflecting where they might be with less Fed intervention. The Fed is not considering lightening up on the QE throttle because it believes the economy is exceeding VH (for those who are aeronautically challenged – Maximum speed in level flight at maximum continuous power). Rather, the economy might finally safely above stall speed, or VS. It is turning off the afterburners, but will keep the throttles (Fed Funds Rate) wide open.
The challenge is to separate the assets which have performed well due afterburners, wide-open throttles or just because the economic aircraft is aloft. We would break it down this way.
High risk assets, such as CCC and even some B-rated loans and bonds have needed afterburners to keep flying. High-B and BB-rated debt benefit from traditional policy accommodation as well as QE. They could perform well for several more years. BBB and A-rated debt perform well as long as the economy remains aloft (expanding) at almost any speed. These companies tend to have solid business models and can service debt, even at higher rates. AA and AAA-rated bonds could underperform pricewise as many investors who feared a crash booked passage on craft which are the fixed income equipment of lighter-than-air vehicles. These bonds would stand a very good chance of paying off, even during extended economic downturns. Some of these passengers might choose to book passage on BBB and A craft.
A Mature Outlook
Notice we have discussed actual debt, and not funds. In our view, most bond funds are not true income oriented investments. Yes, some funds have income as a stated goal. It is true that some exchange traded vehicles have final maturities, but they still are not bonds. Since most investors who purchase fixed income fund shares do so via traditional mutual funds and ETFs we will stick to this area of the fund market. Investors must understand that traditional funds and ETFs have no maturities. As bonds in the funds come due, they are replaced by new bonds. On and on they go. Investors are essentially making equity-like speculations on the asset price of bonds. This strategy is more akin to trading than investing. A bond investor can make money even if interest rates skyrocket and the price of his or bonds by simply holding to maturity. One can buy a 10-year bond now at 100. If 10-year rate rise 100 basis points, the price might drop to 93 or 92. However, in 10-years (as long as the issuer is solvent) I will receive 100 at maturity plus periodic interest payments. What will your bond fund be worth in 10 years? Your guess is as good as mine.
The bond provides another advantage. It becomes less volatile, form a duration perspective, as the years go by. In five years, today’s 10-year note is a five-year note. Duration math indicates that the price of a five-year note is about half as volatile for a given move in interest rates than is a 10-year note. Inexperienced investors might surmise that one should purchase only short-term bonds to avoid duration-related volatility. That might work when the curve is flat or inverted, but yield curves do not maintain any particular shape for long periods of time. In our opinion, the best way to manage duration risk is to ladder a portfolio. Ladders do not have to be equally weighted. Depending on interest rate and economic conditions, and projections (not to mention investor goals and risk tolerance), the risk and duration can be adjusted over time. The bottom line is: when it comes to income investing, maturity and diversification matter.
If one is betting that a fixed income asset class will rise in value, one may want the large degree of diversification provided by a fund. However, this is if one’s goal is capital appreciation. If I had a 75-year old moderate-risk client who had income and preservation of capital as a primary objective, an emerging market bond fund would not be among my top choices. Betting on EM, via any asset class, is pure speculation.
By Thomas Byrne - Director of Fixed Income - Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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