Market Beat: ZIRP and bond risk
ZIRP is an acronym that stands for “zero interest rate policy.” For the last five years, the Fed has employed a zero interest rate policy to help stimulate the economy.
Investors need to understand all of the risks that their hard earned investment dollars can be exposed to. Most investors buy stocks and stock mutual funds when they’re in the accumulation phase of their retirement planning.
As they age they become more conservative and begin to mix in more bonds. A typical asset allocation at retirement might be a mix of 60 percent stocks and 40 percent bonds with the idea that most retirees will shift more toward bonds and less toward equities as they age.
The traditional thinking is that bonds are less risky than stocks. In general, it is true that bonds have less risk than stocks. However that doesn’t mean that bonds and bond funds are risk-less.
The record-low interest rates that we’ve seen recently have sent many investors into riskier assets seeking higher yields to maintain their incomes. Retirees have put more money into dividend paying stocks and high yield bonds seeking cash flow.
In a normal interest rate environment, a person fortunate enough to have $1 million to invest could expect to receive an income of about $45,000 per year by investing in 10-year U.S. Treasury bonds, considered to be the safest investment there is.
Currently, the yield on the benchmark 10-year Treasury is about 2.5 percent, so you can only get about $25,000 per year on that same million-dollar investment.
People who have invested in high yield or junk bonds trying to maintain their incomes need to be aware of the risks involved. Bonds are subject to both interest rate risk (the downdraft in prices when rates rise) and default risk.
Default risk is measured by the credit rating. Historically bonds rated single A or better have a very low default rate. From 1982-2008 there was never a default in a AAA rated bond.
But the historic default rate is 7.28 percent per year for single B rated bonds. Bonds with CCC to C ratings have an annual historic default rate of 22.67 percent.
Junk bond funds with a yield of 5 percent or so may seem attractive today, but may not be compensating investors sufficiently for the credit risk (to say nothing of the interest rate risk).
Some day, the Fed will have to end ZIRP and markets can move rapidly when there is even a hint of change.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.