CHASING YIELDS COULD LEAD TO NASTY ACCIDENTS
The combination of stubborn recession and fallout from the excesses of the 1980s is putting millions gf Americans through the financial wringer. True, the stock market is near its all-time high. But home values are falling. Some insurance companies are defaulting on annuities. High-yield bonds have turned into outright junk. So just when safe products such as certificates of deposit seem to make the most sense, their yields are tumbling. And the decline in rates is not temporary.
In the 1990s, overall yields will be substantially lower than in the 1980s, and for investors to get higher returns, they'll have to take much higher risks. As recently as 16 months ago, short-term certificates of deposit yielded close to 8%. Today, that same six-month CD is paying about 5%. "People have been spoiled by the high returns that have been available on short-term debt instruments," says Michael Metz, chief investment strategist with Oppenheimer & Co.
LEVERAGE HURTS. People have also been spoiled by the seemingly uninterrupted appreciation in real estate values. But now the payoff from buying a home is no longer assured. "For the first time in many people's lives, they've been burned by real assets," says Stephen B. Timbers, chief investment officer with Kemper Financial Services. The idea "that leverage can hurt you, that real estate isn't a sure thing, will be emblazoned on people's minds for a long time." "Those days of open-ended asset appreciation are over," agrees Stephen S. Roach, senior economist with Morgan Stanley & Co. The '90s, he says, will see a shift of assets away from real estate and other tangible investments into financial assets.
And in shifting to financial assets, the decline in rates is pushing investors toward longer-term securities. A year ago, the 30-year Treasury bond yielded only 1.5 percentage points more than the three-month Treasury bill. Today, the gap has widened to a more lucrative 3 points. "People are under tremendous pressure to lengthen the maturity of their portfolios," says Timbers.
To get a sense of just how much pressure exists, look at the money pouring into higher-yielding--and riskier--bond mutual funds. This year, as of August, almost $40 billion of new money has flowed into bond funds, compared with $6 billion for the same period in 1990, according to the Investment
Company Institute. An increasing amount is coming out of banks, where competition for CD investors and passbook savings accounts has dried up, along with attractive lending opportunities. As long as inflation is low and the economy sluggish, the inflows into individual bonds and bond funds are likely to continue. But investors have to expect volatility. On Oct. 21, talk of a tax cut, which could add to inflation, sent the price of the 30-year Treasury bond down about $13.75 per $1,000. If that talk becomes a reality, bonds could tumble a lot further.
RISK APPRECIATION. In the quest for higher yields, individuals may be taking on risks they don't fully understand. Funds that invest in mortgage-backed securities issued by government agencies such as the Government National Mortgage Assn. have attracted many investors with their 8% yields and minimal credit risk. But there is a major drawback to such "Ginnie Mae" funds. As interest rates fall, holders of mortgages are more apt to prepay, or refinance, mortgages. That returns money early to the fund, which reinvests it at lower rates, lessening the fund's stated yield. If frustrated shareholders yank their money, the loss of principal could be substantial as the share price of the fund drops.
More innovative products are being rolled out to meet investor demand. One of the newest is the adjustable-rate mortgage (ARM) fund, which buys mortgages with rates that are reset periodically, rather than being fixed for the life of the mortgage. If interest rates plummet, more flexible ARMs won't lose as much value as mortgages with fixed rates. But investment advisers have a basic concern. Since homeowners are more likely to be locking in fixed rates today, they wonder if an imbalance in the supply and demand for adjustable-rate securities will develop. If supply shrinks as demand grows, the underlying securities could become more expensive and pull down yield.
Even the stock market is attracting CD money. Conservative stock mutual funds have been one beneficiary, but some investors are buying stock directly. Overall, equities are yielding only about 3% in dividends, but investors are waking up to the idea of total return--which includes capital appreciation.
There's nothing inherently wrong with reaching for higher returns. But as people chase yield, they have to understand that the accompanying risks could trip them up.Suzanne Woolley in New York