The Outlook for High Yield Bonds

High yield bonds have done well since the end of the global financial crisis, providing positive returns of at least 5% every calendar year since 2009. This performance has largely been driven by an improving economic outlook combined with low (and generally declining) interest rates. As the Federal Reserve cuts back on its attempts to stimulate the economy and gets closer to raising interest rates, are the good times coming to an end for this asset class?

The answer depends on the relationship between interest rates and the performance of high yield bonds, which is more complicated than for investment grade bonds. Like investment grade bonds, high yield bonds are hurt by increases in interest rates since the fixed amount they pay to investors becomes less valuable. But higher interest rates could also be indicative of a stronger economy. Since a large portion of the return that investors get from high yield bonds is compensation for the risk that the borrowing companies could default on their debt, high yield bonds could benefit as a stronger economy reduces this risk.

High Yield Spread

The risk of default is represented by the difference between the yields on high yield bonds and the yields on treasury bonds. The problem for investors in high yield bonds is that this difference (called the “spread”) is already fairly low by historical standards. Even if the pace of economic growth substantially quickened, it’s unlikely that the spread would fall much further.

The outlook for high yield bonds therefore isn’t symmetrical. As long as the economy continues to grow and interest rates stay relatively low, high yield bonds are likely to continue to offer solid returns. But the potential upside for this asset class is limited by already low spreads, while higher interest rates or a weaker economy create downside risks.

The Possibility of European Deflation

Euro zone inflation rate

The euro zone has struggled mightily in recent years, with its economy shrinking in both 2012 and 2013. Now it faces a new worry. Inflation in the euro zone has fallen to a 0.4% annualized rate, well below the target of close to 2% set by the European Central Bank (ECB) and close to outright deflation. The dangers of high inflation (a sustained rise in the prices of goods and services throughout the economy) are well known: it reduces the value of people’s savings and can make individuals and businesses reluctant to invest. So shouldn’t deflation (a decline in prices) be beneficial? Not exactly.

There are a number of ways that deflation harms an economy. First, since the amount owed on loans and bonds stays the same even if the price of goods and services decline, deflation can make it more difficult for individuals, businesses, and governments that have borrowed money to get out of debt. Just as inflation hurts bondholders, deflation hurts debtors.

Second, it tends to be easier for companies to raise wages than to make their employees take pay cuts. Therefore if prices are declining so companies can’t pay their workers as much, they are likely to lay off more employees, leading to higher unemployment.

Third, when people see prices falling they may respond by postponing their purchases until prices go down even further. A decline in prices can therefore lead to reduced demand, causing further price declines (a “deflationary spiral”).

The euro zone may already been feeling some of these effects, since they can start to kick in when the inflation rate is persistently low, even if it’s still above zero.

Unlike the central banks of other developed countries such as the US, UK, and Japan, the ECB hasn’t engaged in “quantitative easing” (essentially creating new money and using it to buy bonds). This difference is one reason why expected future inflation is now substantially lower in the euro zone than in the US or UK. To avoid the perils of deflation, the ECB may need to take more aggressive action to prop up the continent’s economy.

The Problem with “Chasing Performance”

Chasing

Many investors tend to favor funds that have recently done well. This habit is sometimes called “chasing performance” since these investors are constantly trying to get their portfolio to catch up with the results of the top funds. But is it an effective way to invest? That depends on whether funds that have done well in the past are more likely than other funds to do well in the future. And according to a recent study by Vanguard, that’s not the case.

The Vanguard study used simulations based on historical data from 2004 through 2013 to compare two different investing strategies. The first strategy involved selling funds that had underperformed during the past three years and buying funds that had outperformed. The second strategy involved simply holding onto the funds rather than buying and selling based on their recent performance. The study found that the second strategy did substantially better in every fund category that was tested.

The study doesn’t speculate on why chasing performance leads to poor results, but there are a few likely explanations. Funds that have done well may have benefited from a specific short-term trend in the market, such as good performance in a specific sector. If the fund manager’s approach always favors investments in this sector, the fund is bound to underperform once the short-term trend reverses. It’s also possible that the act of chasing performance itself hurts better-performing funds: as more investors shift into these funds, it’s harder for the funds to find good investments to make with all the new money.

The bottom line is that funds that have recently done well often aren’t the same ones that do the best in the future. Frequently buying and selling to replace underperformers with outperformers is a recipe for lower investment returns.

How Much Should You Put Into Retirement Accounts?

Piggy Bank

Taxes can be one of the main drags on the growth of your portfolio. That’s why tax-advantaged accounts such as 401(k) and IRA accounts can be such a boon when you’re saving for retirement. But how much should you put into these accounts as opposed to regular taxable accounts? The answer is “as much as you can” in order to minimize your tax bill, though there are a couple key constraints on how much you “can” allocate to these accounts.

This first constraint is that there are usually large penalties if you withdraw money from tax-advantaged retirement accounts when you’re under the age of 59 ½. Therefore any money you think you’ll need to pay for expenses before that age shouldn’t be put in a tax-advantaged account. You should also make sure you have money set aside outside of retirement accounts to act as a buffer against unexpected expenses. Once you’re established this buffer, you should put as much money into tax-advantaged accounts as you can afford to.

The second constraint is legal: the government puts a cap on how much you can put into retirement accounts each year. The annual limit on how much you can contribute depends on the type of retirement account. In 2014 the contribution limit for 401(k) accounts is $17,500, for example, while the limit for IRA accounts is $5,500. These contribution limits are higher for people over the age of 50.

Putting as much money into tax-advantaged retirement accounts as you can, while avoiding the penalties you’d have to pay if you withdraw money early or exceed the annual contribution limits, can make it substantially easier to meet your retirement goal.

The Fallout from Argentina’s Default

Argentina Flag

Last week Argentina defaulted on its debt for the second time in the last decade and a half. That’s not good news for investors who own international bonds, and headlines such as “Argentina’s default could hurt the world” and “Not just Argentina: 11 countries near bankruptcy” suggest that the Argentina’s travails could have a ripple effect around the globe. Despite the ominous headlines, however, the fallout is likely to be minimal.

To understand why, recall the series of events that led to Argentina’s most recent default. The country previously defaulted on its debt in 2001 following a severe recession that forced it to substantially devalue its currency. To get back in the good graces of global financial markets, in 2005 and then again in 2010 Argentina reached agreements with most of its creditors to restructure its debts. A few creditors, led by a US hedge fund called Elliot Management, refused to accept the deal and sued to try to get fully repaid. A judge ruled that Argentina couldn’t pay only the creditors who accepted the deal without paying the other ones as well. So Argentina paid nobody, putting the country back into default.

While forcing a country to reach an agreement with every single creditor sounds like a far-reaching legal precedent that could make it impossible for countries to ever restructure their debt, in reality it’s now largely irrelevant. Bonds issued by countries now typically include “collective action” clauses that force creditors to accept a restructuring if a vast majority of the other creditors have already accepted it. A collective action clause kicked in when Greece restructured its debt in 2012, for example.

The confluence of events that led to Argentina’s predicament therefore seems like a unique situation rather than a blueprint for what other countries will experience. While defaults are never a positive sign for bond investors, this one is unlikely to have widespread effects.

The Pros and Cons of MLPs

Pipeline

Most stocks are fundamentally the same kind of investment: they’re shares of ownership in a corporation. There are a few exceptions, however. One is “Master Limited Partnerships” (MLPs), which are popular among many investors because they tend to have very high yields. MLPs trade on stock exchanges just like other stocks, but there are important differences from both a legal perspective and an investment perspective.

MLPs are mostly energy companies, such as companies that operate the pipelines that transport oil and gas across the US. They’re technically “partnerships” rather than “corporations” so their profits can go straight to their shareholders without being taxed at the company level. As a result of the tax laws related to this difference, MLPs distribute a large portion of their profits to shareholders, making them very high-yielding investments. They also have additional tax advantages: for example, a large portion of the distributions are usually taxed when you sell the investment rather than immediately when the distributions are paid.

Of course there are plenty of drawbacks to MLPs as well. Since MLPs are generally energy companies, having too much exposure to them can make your portfolio vulnerable to a downturn in the energy sector. Furthermore, since MLPs distribute almost all of their profits to shareholders, they regularly need to raise new money to maintain and grow their business. This can make them sensitive to problems in financial markets: many MLPs struggled to raise funds at attractive rates during the financial crisis.

In sum, MLPs can be an effective way for investors to generate income from their investment portfolio and get some tax benefits to boot. But like most types of investments, having too much exposure to MLPs can create substantial risks.