On March 13, Federal Reserve Chairman Ben Bernanke reiterated the Federal Open Market Committee’s intention to keep interest rates low through 2014. This is welcome news for mortgage borrowers or those invested in equities, as investors may decide to move to riskier assets rather than earning next to nothing in a money market, as discussed in a previous article.
With inflation running at about 2.5 percent, parking cash in a bank these days erodes purchasing power, resulting in negative yield.
Given the current environment, it is not surprising that many investors are now chasing yield. However, my concern is that they are doing it without fully understanding the downside risk.
Bonds, including those considered “high yield,” have experienced a large influx of investor cash over recent months. High yield bonds generally offer a better return than high-quality government bonds, in exchange for taking more risk. Yields are higher, of course, due to the increased chance of default, so if investing in high yield bonds, it may be advisable to invest in a mutual fund, an ETF or a separate account.
Having your high yield exposure concentrated in just a few companies would be devastating if one of those companies were to default.
When rates move up, the value of your bond holdings will go down. Interestingly, though, due to the higher coupon rate on a high yield bond, there is less exposure to principal erosion as general market rates move up.
There are also funds that hold floating rate bank loans. Because the rates banks charge borrowers typically adjust monthly, the yields paid to these fund investors fluctuates. This could be a good way to mitigate interest rate risk. The yield is again dependent on the average credit risk in the loan portfolio and diversifies the risk across many companies.
The U.S. economy is clearly in recovery, albeit at a slow pace, and if you believe that recovery will continue, corporate bonds may be a nice alternative to U.S. Treasurys or bank money markets. However, be aware, particularly when investing in bond funds, that you fully understand the holdings within the fund and the manager’s investment strategies and objectives, and that it fits within your overall portfolio.
An interesting conversation I am hearing with increased frequency is about seeking yield by investing in foreign currency income funds. The euro is typically not the currency of choice in these discussions, given the looming economic recession in Europe. Many believe that some emerging market countries offer attractive interest rates and opportunity for currency appreciation — Brazil, Uruguay, Columbia and Peru were cited in a recent conference I attended.
I would not recommend that any of these strategies be pursued without professional advice. Any or all of them may complement an investor’s portfolio, but not every investor. Yield without risk is nearly impossible in this environment. Your individual goals, time horizon and risk tolerance are key factors in determining the best approach for you.
Marianne D. Fishler, CFP®, is president and co-founder of Baltimore-based Foundry Wealth Advisors LLC. Investment Advisory Services are offered through Donnelly Steen & Co. d/b/a Foundry Wealth Advisors, a US SEC Registered Investment Advisor, 1201 N. Orange St., Wilmington, Del. Securities are offered through Coastal Equities Inc., member FINRA/SPIC, 602 Main St., Cincinnati, Ohio. Foundry Wealth Advisors LLC is a separate company from Donnelly Steen & Co. and Coastal Equities Inc. Contact Marianne Fishler at email@example.com or 443-692-8833.