Is It Safe to Chase Yield in Retirement?
As more Americans reach retirement age, demand for fixed income is higher than ever. Supply, however, is harder to come by. While U.S.Treasurys were once the bedrock of retirement income, consistently low yields are sending retirees into riskier investments.
Larry Yates, 73, is a retired teacher who manages his own portfolio. "You've got to put yourself at risk if you don't want everything to be eaten up by inflation. I'm conservative, but I'm not going into a bunker here," said Yates. "Our portfolio needs to be growing."
With this, Yates unintentionally hit on a popular trend among retirement fund managers. Being "conservative" doesn't mean what it used to. Today, achieving a return on principal rather than return of principal, requires more risk.
This, in any case, is the prevailing strategy among retirement fund managers in the U.S.
(Read More: Ready to Retire? What to Do Before You Tell Your Boss.)
Among mutual fund bond funds -- the most common retirement investment vehicle -- the most popular asset class in 2012 was corporate bonds. Yet high yield bonds and emerging market bonds saw the second- and third-largest net asset allocations, according to year-to-date Morningstar estimates.
Traditionally considered inherently risky assets, high yield bonds, emerging market bonds, and high yield municipal bonds attracted $28 billion, $19 billion and $11 billion, respectively, so far this year, Morningstar said. By comparison, Treasury in-flows are nonexistent.
Retirees and their fund managers are clearly on the hunt for higher yields.
"People are afraid of running out of money. Many retirees looking to grow their principle are choosing more aggressive funds," said James Martielli, senior investment analyst at Vanguard, the largest mutual fund company in the U.S. "It's not a guarantee, but the biggest driver of relative performance is overall risk."
Martielli's comments came as Vanguard's competitor BlackRock released a bullish outlook on certain "risky"assets, including high yield and U.S. municipal bonds,according to its 2013 outlook report.
As for 2012, here's a snapshot of YTD returns:
High-yield corporate bonds: Traditionally known as junk bonds, these historically have a higher default rate than investment grade corporate bonds. In the last 12 months, they have increased 6.48 percent, according to the Merrill Lynch High-Yield Index .
High-yield muni bonds: Bonds issued by municipalities or states with a sub-investment grade credit rating. SPDR Nuveen S&P High Yield Municipal Bond ETF is a representative of this market, up 11.9 percent over the past 12 months.
Emerging market bonds: These bonds are issued by emerging market countries and/or companies. Yields can vary widely by country, but the most popular index, the J.P. Morgan Emerging Market Bond Index, posts a 15.5 percent return for the past 12 months.
(Read More: Six Tips for Boomers Looking for Work.)
Suffice it to say these options all trump 1.65 percent, the current yield on 10-year Treasurys. Yet many experts warn that retirees, especially, should not be chasing yield. After all, conventional wisdom says high-yield assets are high-yield because they have a greater likelihood of default.
"People are chasing yield. That's a fool's game. The risks haven't changed," said Ron Weiner, President of RDM Financial Group, a financial advisory firm. "Bond funds are susceptible to changes in interest rates, and they're really just a bet on a sector and the interest rates in that sector."
Weiner favors investing in individual bonds over bond funds,as seeing a bond to maturity allows for more certainty than a bond fund, which restricts investors' visibility on individual bond prices. On the other hand, RDM Financial Group does have exposure to Pimco's Emerging Market Bond Fund.
It seems that in general, emerging market bonds have gained support among financial advisers, economists and investors alike as a having become less risky overtime.
The safest risk?
Emerging market bonds' acceptance as a mainstream fixed income asset class has grown exponentially since the financial crisis of 2008. That highlighted how poor the developed markets were, and that by comparison; most emerging markets have better debt-to-GDP ratios than the U.S., as data from the IMF's latest world economic outlook points out.
"Emerging market governments have become very responsible. In sub-Saharan Africa, for instance, the government debt is now 35 percent of GDP. For the G7, it's 120 percent of GDP," notes Charles Robertson, global chief economist for Renaissance Capital Research. "The emerging market world has much safer credit, and much better yields. They make a lot of sense."
Nonetheless, arguments against emerging market government bonds cite that sovereign credit can hinge on weak rule of law, or political upheaval. If you're issued a bond, and the country defaults, you can't sue them. There is no recourse.
For Robertson and Weiner, this simply is a sign to be selective. There are vast differences between the creditworthiness of countries like Venezuela and China; or Kazakhstan and Brazil.
"People know the China, India, Brazil story. We're more interested in less well-known stories, like Nigeria. Its GDP is growing 7 percent, and it's an economy doubling every 10 years."
Robertson is most bullish on Nigerian and Russian bond markets.
Location aside, the rule remains: the higher the yield, the higher the risk. Whether retirees are aware of the increased risks taken by fund managers is another question. If not, they do not have working years to retrace their steps and cover their losses. So if you consider yourself 'conservative,' it may be time to compare definitions.