Low Interest Rates Are Fueling The Next Crisis

|
Includes: GPC, JNJ, MCD, RTN
by: The Money Madam

I believe that low, in some cases zero or even negative interest rates will fuel the next crisis. When the next crises comes has not yet been revealed to me through my crystal ball but it is going to happen.

  • Bond bull leads to need for alternatives.
  • Systemic risk not mitigated by regulations.
  • Pressure building on assets and cash flows that back bonds.
  • Dividend income fared the best last time.

Bond Bull

A Bond Bull market means the price of bonds is high. The higher the quality of the bond, the higher the price. When bond prices go up, yield goes down. Take a look at this graph from Bankrate.com that shows the dramatic decrease in yield from CDs (certificates of deposit) over the past 30+ years. (WSJ article by Katy Burns). Later in this article, I provide a link to that article for your review.

Since safe bond prices go up when interest rates go down, you can see that safe bond income is very expensive today.

This equation only matters if you want the safety of a portfolio of investment grades bonds to fund your retirement. How much yield do you need? Four percent seems reasonable. They say you can take four percent out of your retirement and it will last. So if your retirement earns 4%, you should be okay.

What is the reality of buying a safe bond with a 4% yield. This bond is going to cost you more than the bond will pay back when it matures. For instance, you pay $101 for a bond that pays you back $100 in 10 years and in 10 years, inflation has eroded that $100 even more you made a bad investment. Where do you go for income? This low interest rate scenario sets the stage for "alternatives."

Alternatives

Alternatives are creative ways to raise money by pledging not just assets, but also cash flows to you the lender. You get a share of the assets pledged which could be a building or other hard asset. Or, the money you lent could be backed by an income stream such as someone else's mortgage or the cash flows from a business. They get even more exciting when a firm clumps them together, then dices them up again and sells you a piece of the pie. This is called a securitized debt.

Collateralized Debt Obligations or CDOs are complex. Click here to read Investopedia's definition of CDOs.

Look at this chart and you will see how these instruments proliferated before our most recent major market disruption in 2008.

While ordinary investors should be averse to so complex an investment, many people fell for this type of "alternative program" time after time. If they could get more income, life would be better. Sold as an income instrument CDOs and their first cousins CLOs (collateralized loan obligations) and CAOs (collateralized assets obligations), CMBS (commercial mortgage backed securities) deliver higher income and higher total return when they work.

This article from Knowledge@Wharton, University of Pennsylvania in 2013 is a must read if you want a good review of these investment ideas. Risks are covered in this article but they suggest that things are different now: published in (2013).

In 2017, these investments are tempting for ordinary investments but even more tempting for institutions who must deliver more income than they can get from safe investments. Teachers unions, municipal pension funds, hedge funds are the big market for these investments. If you are a beneficiary of any of these investment pools, the risk is on you.

Systemic Risk Still Exists

Why are these investments coming back? The answer is need for yield. Harvard published a review of regulatory changes resulting from the 2008 crisis. A link to the article is here.

The Economist published this graphic that illustrates that few things have changed: "Old alphabet soup, new taste."

Another sign that regulation has not mitigated risk is provided in an article by Katy Burne in the Wall Street Journal where they discuss the repo market. Repos buy bonds with borrowed money sort of like buying stocks on margin. Repo's are now processed by only one bank. Whenever one institution is a key to this much debt, systemic risk is real.

The Pressure Builds

Speaking of "new taste." Ben Eisen in the Wall Street Journal "Restaurants Like This Debt Flavor."

In this article, a debt instrument called "whole business securitization" is popular among restaurant stocks. They can pay a little less interest than they would have to pay in the junk bond market. The 'securiter' matches this need with investors who need more income than an investment grade bond can deliver and they sell this new idea as safer because you own a piece of the business. As Eisen notes, the lender and borrower have to iron out what happens to the debt in a bankruptcy. But the pressure is on and these loans are increasing. Eisen states the volume of these types of loans is greater than occurred before 2008.

This "whole business securitization" came about in the U.K. in the 1990s. Lehman Brothers borrowed (pardon the pun) the idea in the run up to 2008. We all know what happened to Lehman Brothers; bankruptcy.

Another sign of trouble is well documented by Christopher Whitall and Mike Bird in the Wall Street Journal 8/29/2017 "Crisis-Era Scourge Reignites Worries." Click here.

Dividend Income Is The Alternative

Actual personal history is important to me. I have been through many market crashes beginning with 1987. The October 1987 crash was not too bad for me. I was able to refinance my mortgage as rates went down and still I could use my savings to buy a 1-year C.D. for 7%. I didn't own enough stock or enough real estate to be affected by the stock market crash. All I cared about was working. I had no idea about synthetic investment but the junk bond debacle was the fuel of that awful fire. I got through it because I was young and working. Retirees had it a lot worse.

In the early 1990s, I decided to join this business of investment advising. The 1992 and 1994 recessions were challenging. Already in my early 40s, I knew that creating investment income to replace my working income and my spouse's was the single most important financial goal of our investment plan. I started to use these market disruptions as an opportunity to employ cash.

During the early to mid 1990s, we created cash by spending less than we made; better known as savings. Every extra dollar went to investing for our future income.

By the time the next major disruption occurred in 2001, I was still working but my husband had retired. The dot com crash of 2001 was painful. It tested the theory that it doesn't matter what your portfolio is worth, what matters is what income it creates.

The absolute worst scenario is to have the market crash just when you retire. In 2001, I couldn't afford to sell because I needed the income from our portfolio of quality dividend stocks and some quality bonds we so carefully built and the real estate I invested in that an MBA classmate of mine put me into. A few stocks did reduc