I arrived in Toronto in the late 80’s and was involved in mortgaging real estate as the prices skyrocketed. Today it is no big shock to look back and see how the late 80’s real estate collapse was inevitable. Buying real estate in 89 was dumb....in retrospect. Similarly we can look at the stock bubble of 1999 known as the tech wreck. To those that bought a house in 1989 and then put their RRSP savings into Nortel....well our heart goes out to you!
The incident of back to back bubbles is obviously not unheard of. As money fled real estate it crowded into high tech stocks to create the perfect conditions for the double whammy. So how does this relate to today’s market? Well, money fled the stock markets in 2008 and as stocks crashed large amounts of capital began to flow into fixed income investments. The net result appears to be the creation of a perfect scenario for the second half of the double whammy.... a fixed income crash.
In the case of fixed income, there is even more reason for concern than usual due to both behavioural and macro economic factors. The behavioural concern is the belief by many investors that bonds are inherently low risk. This means investors often choose not to pay close attention to the fixed income markets and price fluctuations. As well, many investors unfortunately have an inflated sense of their knowledge of how securities work (as validated by Zweig ). Fixed income instruments such as bonds are interest rate sensitive (duration) and move inversely to the movement of interest rates. If rates rise then fixed income markets drop in value. Also, if the economy weakens then debt instruments like fixed income face credit defaults which cause values to drop as well.
When you combine those facts with the current macro scenario of historic low interest rates and very low economic growth, you create the conditions for a fixed income disaster! Investor capital will flow to wherever they can find better yield. When that happens, the product vultures kick into gear and create “high yield” products to sell to the retail markets. For those who are kicking the tires on fixed income it may not be apparent that “high yield bonds” are known in the business as “junk bonds”. Once again we see retail investors pouring money into opaque fixed income and yield products, ignoring risk and paying higher fees that often exceed the yield they might gain.
It very much looks like the double bubble process has begun! Every investor seems to be “seeking yield” and new product offering are focused on lowering the bar on bond quality. Junk bonds are now buried in “hybrid fixed income” funds and every fund firm is keying the marketing department to hype higher yield going into the 2011 RRSP season. ETF’s are not excluded as iShares launches its new HYbrid fund, joining the BMO High Yield Corporate (U.S) fund launched in late 2009, the iShares U.S. High Yield Bond index launched in early 2010, and a slew of others. According to IFIC the global and high yield bond funds market sales are up 62% year over year to August 2010.
Hang on tight folks. The bond world can be cruel to those who see it as a sleepy back water investment. With cash flow and capital far exceeding the equity markets, bond markets are dominated by the big players and are far from being a transparent playing field. Just when you think you are finally safe investing your hard earned savings again.....WHAM!
Anecdote: I just spoke with a DIY investor who told me he has purchased a fund of emerging market high yield bonds...... what could go wrong!