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Chasing yield. It’s an investing term that sounds so innocuous. And I hear it thrown around on CNBC and in print as if it’s nothing to worry about.
But it is. In fact, it’s one of the biggest dangers that investors — and the economy overall — face in an artificially low-rate world like the one the Federal Reserve has created.
Heck, I’d describe “chasing yield” differently — rephrasing it as “Buying huge amounts of junky bonds and ridiculously overvalued stocks and real estate ventures just because they’re promising high payouts and yields — payouts they will never be able to sustain!”
Kinda puts a different spin on this dangerous trend, eh? So how can you protect yourself? Why am I getting so worried about this problem again? Let me explain …
Chasing Yield Ends in Tears
When You Lose Sight of Risk!
If you look at where investor money is flowing these days, one thing jumps out at you: Taxable bonds are sucking up cash like never before!
Despite the double-digit rally in the broad market averages so far in 2012, investors withdrew a whopping $77 billion in money from domestic stock funds through August, according to the Investment Company Institute. At the same time, they poured $169 billion into taxable bond funds.
This isn’t a new trend either. In 2011, $132 billion in money came OUT of stock funds. Some $135 billion flowed IN to bond funds.
Now as I noted last week, bonds CAN be safer than stocks. But it depends on what kind of bonds you’re talking about.
Long-term government bonds can implode in price if interest rates rise, due to a bout of inflation, a decline in sovereign credit ratings, and more. We’ve seen sovereign bonds collapse in value in Greece, Spain, Ireland, and other countries already!
Foreign bonds can lose value if the currency they’re based in declines against the dollar. U.S.-based holders of euro-denominated bond funds got hammered in late 2011 and again in early 2012 when the euro plunged.
Then there are high-yield bonds, colloquially known as “junk” bonds. Investors have been chasing these bonds like nobody’s business, buying a record $34 billion in the first nine months of the year.
This has provided all kinds of high-risk companies with an unbelievable amount of flexibility when it comes to raising money. They’ve sold a whopping $247 billion in junk debt so far in 2012, roughly DOUBLE what we saw in the midst of the last credit bubble created by easy Fed money in the mid-2000s!
Worse, the percentage of companies in the lowest credit rating tiers issuing bonds is rising vis-à-vis their higher-rated brethren. And companies are changing the terms of their bond sales in ways that offer investors less protection against credit losses if business goes south. These are precisely the same things we saw happen in the mid-2000s, a period that preceded the biggest crash in junk bonds ever!
Finally, I’m seeing money pour into higher-yielding stock investments like Real Estate Investment Trusts, or REITs. These companies own commercial real estate such as office buildings and apartments, and pay out dividends with the cash they raise via rents.
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| Investors drawn to high yields in real estate, are ignoring what happened during the last crash. |
Since REITs are “bond-like” investments, they’re benefitting from the same kinds of flows that are driving junk bonds. This despite the fact we’re only a few years past the LAST real estate crash.
What You Should Do
in this Tricky Environment
I understand WHY so many investors are chasing these kinds of products — they yield 5 percent, 6 percent, 7 percent, or more in a world that’s starved for income. Short-term securities pay virtually nothing, and even the 10-year Treasury Note yields just 1.75 percent.
But ask yourself: What happened the LAST time the Fed artificially suppressed rates and inspired an epic bout of yield chasing? How’d that work out?
The benchmark ETF that tracks REIT shares — the iShares Dow Jones U.S. Real Estate Index Fund (IYR) — lost 78 percent of its value from peak to trough. A leading ETF that tracks junk bonds — the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) — tanked 42 percent.
Are we going to see another epic implosion like that? I can’t say. What I can say is that some investors are taking the Fed’s yield-chasing bait … and many of them are going to get hooked if rates rise, credit quality declines, the economy weakens, sovereign ratings pressure builds, and more.
So if you’re overloaded in these sectors, especially junk bonds and REITs, strongly consider paring down your risk. If you need income to pay your bills, consider less-risky dividend paying stocks in sectors like utilities and consumer staples. I also like more highly rated corporate debt and Master Limited Partnerships (MLPs) as better alternatives.
You can find some of my favorite names in the Safe Money Report. You’ll also learn about some hedging strategies that can help protect you against the risk of yet another implosion brought about by yield chasing. Just click here to learn more.
Until next time,
Mike
Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.
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This article should cause some investors to question some of their actions….especially the action of chasing yield. I totally agree with the author. In investors attempts to get some type of yield in this low yield environment, we decide to risk everything on bonds that are one notch above junk status. For example Spain. With all the growing issues going on over there, you would think that their bond auctions would be horrible. But in actuality, they had pretty good auctions over the last two months and the yields have been falling until recently.