Retirees Embrace Junk Bonds at Just the Wrong Moment

Yield-starved retirees are taking a flyer on junk bonds, just as credit quality in that market takes a turn for the worse. Look out below.

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The search for yield is reaching a crisis state. In the past few years, millions of retirees have curbed spending, gone back to work, or drawn down assets at an unsustainable pace in order to make ends meet. Fed up, they now appear to be taking on additional and probably inappropriate levels of risk.

Low interest rates are, of course, a boon for borrowers. And as Fed Chairman Ben Bernanke has said, low rates are good for everyone in that they will help revive the economy. But extremely low rates for an extremely long period, as we have experienced, takes a heavy toll on seniors—many of whom diligently saved for a lifetime and had every reason to believe they were set.

Savings rates and money market funds now yield as little as 0.01%. Even a five-year bank CD yields less than 1%. The 10-year Treasury bond yield is just 1.74%. Such paltry payouts have forced 42% of retirees to cut spending, according to one survey. Countless others have gone back to work. Low rates have driven up the cost of guaranteed lifetime income products such as fixed annuities and laid waste to the rule that retirees can safely draw down 4% of assets each year. The new mark may be 3% or less.

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So it should come as no surprise that retirees are desperately seeking higher yields, damn the risk. This is partly visible in the year-long run up of blue chip stocks that pay a dividend. Some now argue that dividend payers are in a bubble. But others maintain that these stocks are a reasonable move for retirees, if done through a diversified product like a stock mutual fund or ETF. You can still find yields around 4%.

The clearest sign of seniors ratcheting up the risk dial is in the junk bond market, where trouble unmistakably is brewing. Corporations with low debt ratings—junk bond issuers—have been minting new bonds at a breakneck pace, largely because investors have been willing to snap up their debt to lock in yields of 6% or more.

Junk bonds are a high-risk asset in any environment and should never amount to more than around 10% of an overall portfolio. Some retirees have found comfort in the relatively low default rate of junk bonds in recent years, and analysts generally liked how the new money was being used—typically to refinance older debt and lengthen out the payback period, driving down the company’s monthly costs.

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But with such demand for the bonds in this low-rate environment, the credit quality of typical issuers is falling and the money is being put to more questionable purposes. The average credit rating of the companies issuing junk bonds has slipped to C ratings from B ratings. Meanwhile, The New York Times reports that more proceeds are going towards riskier ventures like mergers and acquisitions and to fund huge one-time dividends to private equity owners. Junk bond issues from Jo-Ann Stores and Petco are two recent examples.

Some now believe that defaults are due to rise and it seems clear that retirees are not aware of this deteriorating credit quality. From the Times:

“Figures from the data company EPFR show that wiser institutional investors have begun to shift money out of junk bonds, as individual investors have continued to pour in. Retail investors added about $2.1 billion to their portfolios in the first three weeks of October, compared with a net outflow of $256 million from institutional investors.”

As long as individuals keep pumping money into mutual funds that buy junk bonds, the managers of those funds will keep buying bonds–even if it means buying ever riskier issues. There has been a lot of talk about bubbles, not just in dividend stocks but in Treasury securities, too. Not a lot has been said about what’s going on in the junk bond market. But that may be where the real trouble lurks, especially for retirees gravitating that direction because they see no other choice.

MORE: Junk Bonds: Wall Street’s Newest Bubble?

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