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The Risk of Stretching for Returns

by on July 20, 2014 7:00 AM

As a result of the Federal Reserve policies, which have lowered interest rates to levels not seen since the 1930s, many investors - especially those investing for retirement income (which includes insurance companies investing to provide cash flow to annuity holders) - have had to scramble to find historically reasonable yields or returns.

If you check with your local banker you will learn that they have no products in which you can safely park your money and earn a historically reasonable rate of return. Rates of return on Treasury Bills, Notes and Bonds are likewise rather skimpy. For example, someone with a million dollars to invest would currently earn just $20,000 annually on a five year commitment. I recall not so very long ago that banks and the Treasury paid well over 6 percent and I can remember certificates of deposit and Treasury obligations paying over 10 percent per year. Times have changed.

Investment managers and investors are currently using various strategies and techniques to stretch their cash flows (interest and dividend payments) in order to meet the needs of the retirement community. To that end, their strategies have taken on a significant increase in risk which is not evident to many investors. Recently a large mutual fund investing in bonds was taken to task by an independent investment advisor.

The issue was that the fund, which apparently has a great reported rate of return compared to its peers, had invested a significant amount in the sovereign debt of countries where such investment could quickly become illiquid, i.e. unable to be sold, if events deteriorated in the investment markets. This potential for an adverse outcome (how I define risk) is not reported in the numbers where returns are the singular investor focus.

To be sure, risk is very hard to measure with accuracy. While the quants have created numerical measures of risk, the actual experience is better measured by taking a long term view of the markets and what has surprisingly happened historically. In the short run, risk can be approximated by looking at the variance in prices (how much they vary in price over time versus the markets or other standards). In the longer run, risk is better measured by looking at the depths of declines that have occurred historically. For example, over the years 2007-2009 the Standard & Poor's 500 Stock Index declined 49 percent. The market has recovered and gone on to new highs since then, but the decline was gut-wrenching for most investors.

With nearly a half century of experience, I can remember in the 1980s when a government bond fund (conservatively invested in US bonds) declined overnight about 20 percent because of an investment strategy that failed. You all know about the losses incurred by the scamming Bernie Madoff, who promised steady annual returns of about 12 percent only to disappoint his many victims who didn't consider the possible risk of investing with an advisor who told his clients they couldn't understand how he made them money. That is a red flag, regardless of who says it. Energy company Enron made the same claim and they are now in the trash bin of investment history.

More recently, a high yield bond fund dropped nearly 90% in value and hasn't recovered since its investment strategy failed miserably in the great crash of 2007-2009, forcing the fund to sell its quality investments (the only ones it could sell) while retaining the illiquid junk in its portfolio. Further compounding the problem was the failure of the mutual fund management company to oversee the activities of their portfolio managers.

In an effort to gain performance and yield, some municipal bond fund managers loaded up on Puerto Rico bonds and, in some cases, suffered 20 percent declines in principle. Long Term Capital Management nearly sank the entire market back in 1998 when their computer designed and executed investment strategy failed. The markets were then saved by former Federal Reserve Chairman Alan Greenspan's arm-twisting the big investment banks to fill a $6 billion pothole in the investment markets. The investors in LTCM however, still suffered significant losses.

As we come to the supposed end of the Fed's bond buying program, QEIII, we face the potential for a rise in interest rates, and things will likely be changing in the investment markets. The risks many investors have been taking might just rear their ugly heads and take a turn for the worse. Pay attention to your holdings and be prepared to move your money as the end of our accommodative Federal Reserve policy becomes apparent. The free lunch part of this economic and investment market recovery might also be coming to an end.


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Dan Nestlerode was previously the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. He retired in 2015 after 50 years in the investment business. A graduate of Penn State University, Nestlerode became an investment advisor in 1965. He can be reached at [email protected]
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