Desperate Measures For Desperate Times

The low interest rate environment is leading investors -- and their advisors -- to desperate measures in an attempt to meet retirement income objectives.  An article in Investment News addresses the dilemma faced by retirees and their advisors whose plans are being foiled by flat equity markets and plummeting interest rates.  Three solutions explored are immediate annuities, high yield bonds, and preferred stocks.

An immediate annuity can be a valuable tool to allow a client to meet objections in the short term while allowing capital markets to do their job and provide a reasonable rate of return for risky assets.  Of  course, an investor will forgo the opportunity for increasing income from the capital devoted to the annuity.  However, this assurance of lifetime income frees the remainder of the portfolio to address the risk of inflation.  Absent the annuity, the portfolio runs a real risk of failing to last the lifetime of the retiree.

The article acknowledges the incremental risks of high yield bonds and preferred stock.  Here is how one advisor addresses the risk:

“We invest in a high-yield ETF with 10 or 20 bond positions that have low management fees, which eliminates the need for us to investigate the company,” said (the advisor).
 
“We’ve been in junk bonds since 2009 and they’re great performers. Unless the entire economy implodes, I think they are a fairly good buy,” (the advisor) said. “The risk is that the issuer can default, which we assess beforehand.”

Very scary stuff.  While an ETF provides liquidity for the junk bond position, its pricing will reflect the marketability of the underlying bonds, and if one of the holdings (about 5% if there are twenty holdings) defaults, that pricing will wilt.  The period since 2009 has seen very positive results for high yield bonds, it has been an unusual period.  The assumption that an economic meltdown would be necessary to have a negative effect on high yield bond returns is unduly optimistic, especially in such a concentrated portfolio.

Of course, the two holdings can work very well together.  The inflation protection of the increased coupon of the high yield bonds offsets at least a portion of the cost of living risk of the annuity, and vice versa.  Which is the whole idea of diversification.