As more future and present Baby Boomer retirees opt for lower risk, they're shifting their portfolios from equities to favor more bonds, asserting pressure on a finite supply of fixed-income instruments, a pool made smaller still by low interest rates. Corporations and municipalities with good credit can now choose bank loans. Consequently, more investors are chasing the same fixed-income offerings, which is pushing bond yields down and portfolio managers to act more creatively.
"Yes, it's worrisome," says Dan Heckman, senior portfolio manager and senior fixed income strategist for the wealth management division of U.S. Bank, in Kansas City, Mo. Traditionally favored tax-free municipal bonds risk is something else his department is "watching very closely." Statistically they're still low on defaults, says Heckman. "Munis continue to do well, despite the cities in California," he says, noting last summer's decisions by several California towns and a county government to consider defaulting on their bonds. If the bank had exited when the first signs of trouble appeared a few years ago, he says, his department would've missed "tremendous returns." So U.S. Bank is staying with muni bonds. "We've done quite a bit of work analyzing which areas of the country may be more susceptible to Chapter 9 filings, and continue to do so."
Taxable munis known as Build America Bonds, or BABs, in which the federal government returned a portion of the bonds' interest to the issuers, were very popular, he adds. But the program and subsidy expired in 2010. Now Heckman is investing in tax-exempt higher yield munis for their return. As he expected, the fed's current Quantitative Easing, now in its QE3 phase, by keeping interest rates artificially low is actually "pushing investors out into riskier assets." In effect investors are penalized for staying in cash or cash equivalents.
The problem is worldwide, as funds seek lower risk and higher yields to make up for shallow returns. In the United States, the current aggregate national retirement savings shortfall as estimated by the Employee Benefit Research Institute (EBRI) is $4.3 trillion (a drop from $4.6 trillion due to automatic 401(k) enrollment). A global survey of institutional investors in last month by Natixis Global Asset Management found 31% of asset managers have lower risk tolerance than five years ago, 84% are increasing allocations to fixed-income assets -- greater than their 79% allocation to global equities.
New thinking is required. Global institutional investors say that "many of the old rules of investing do not apply to current markets," reports Natixis. "The financial crisis of 2008-2009 has changed the way they look at investing." Specifically, 65% say static 60/40 policy portfolios are no longer the best way to pursue return and manage investment risk. And, more than half, 57%, say historical data demonstrating that longer holding periods decrease the likelihood of negative annualized returns are no longer valid. And, more than two-thirds say investors need to replace traditional diversification and portfolio construction techniques with new approaches.
So Heckman's team is also focused on corporate bonds and dollar-denominated emerging market sovereign bonds. Heckman expects to see 4 percent to 5 percent yields in sovereigns as well as currency fluctuations, hence dollar-denominated bonds to avoid currency risk. He also favors high yield non-investment grade corporate bonds, where default risk has dropped to 3 percent and below, and credits QE3 with pushing liquidity up to historic levels. Heckman is confident that his team has "really pegged right the direction of interest rates by pairing them with the employment rate." As long as unemployment stays around 8%, or underemployment at 15%, there is "so much slack in the labor force that the Fed won't be worried about inflation. At this point, we think the Fed is liable to keep the low funds rate longer than the market realizes or wants to accept."
-Maureen Nevin Duffy