Three Ways Income Investors Get in Trouble

By ETFguide.com  MAY 13, 2013 1:52 PM

Instead of taking precaution, many income investors are piling into higher yielding bonds without fully understanding the risks.

 


Here’s an apt description of today’s bond market: It’s a bull market in lunacy.

The Federal Reserve’s zero interest rate policy (ZIRP) has pushed yields on bonds so low, it’s also pushed bond or income investors into assets they would’ve never dreamed of owning. Subcategories within the bond market like emerging market debt and high yield corporate bonds have soaked up billions. And as a result, a nation of conservative income investors has been converted into a nation of lunatics.    

Instead of taking precaution, many income investors are piling into higher yielding bonds without fully understanding the risks. They’re also missing other opportunities to generate high income, but with lower risk.

Let’s examine three ways income investors are getting into trouble. 

High Risk Corporate Bonds

“Junk bonds” or “high yield debt” are corporate bonds issued by companies with a shaky or unestablished credit history. Naturally, anyone lending their money to this type of company should expect a very high yield to compensate for the additional credit risk. Is that happening?

This past week, the yield on the Barclays US Corporate High Yield Index (NYSEARCA:JNK) fell below 5% for the first time ever. Are sub 5% yields adequately compensating bond investors for the type of credit risk packed into junk bonds? Most people buying junk bonds at today’s yields have no understanding of just how dangerous and volatile these types of bonds are.

Going Too Long on the Yield Curve

Another segment of the population is piling into long dated bonds (20-year-plus maturities) to get more yield. Unfortunately, prices for long-term bonds and Treasuries more vulnerable to interest rate spikes. This leaves unsuspecting people open to a world of hurt.

Our view of long-term Treasuries is as a short-term or temporary haven and nothing more. When stock prices finally have their long overdue correction, Treasury prices will spike, creating a short-term trading opportunity. 

Betting on Shaky Countries

Here’s another sign of lunacy in the bond market: Frontier market countries are raising billions of dollars faster than the flick of a switch.

Bloomberg reports that, “Rwanda sold $400 million in dollar-denominated 10-year bonds at an annual yield of just 6.87%.”

Although Rwanda has grown rapidly, around 50% of the population still lives below the poverty line. Approximately 90% of its workforce works in the fields. “As a result, the country is heavily dependent on foreign aid, which covers about 10% of gross domestic product.”

It’s a sure bet that when the next credit crunch arrives, nations like Rwanda will default on their debt. Heck, even developed countries like Japan, Spain, and Italy have the same acute risk!

High Income, Lower Risk

There are much better strategies for generating high income than three examples you just read about. Selling covered call options is just one example. 

Since the beginning of the year, our ETF Income Mix Portfolio has generated over $3,000 of monthly income. How do we do it? Instead of chasing yields in high risk bonds, we use a lower risk strategy by selling covered calls. It allows us to still collect dividends on the underlying ETFs and to cushion our portfolio against market declines. 

Editor's note: This story by Ron DeLegge originally appeared on ETFguide.com.

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