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3 Ways Income Investors Get in Trouble

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May 10, 2013
Ron DeLegge, Editor

Here’s an apt description of today’s bond market: It’s a bull market in lunacy.

The Federal Reserve’s zero interest rate policy (ZIRP) has pushed yields on bonds (NYSEARCA:BND) so low, it’s also pushed bond or income investors into assets they would’ve never dreamed of owning. Subcategories within the bond market like emerging market debt and high yield corporate bonds have soaked up billions. And as a result, a nation of conservative income investors has been converted into a nation of lunatics.    

Instead of taking precaution, many income investors are piling into higher yielding bonds without fully understanding the risks. They’re also missing other opportunities to generate high income, but with lower risk.

Let’s examine three ways income investors are getting into trouble. 

High Risk Corporate Bonds
“Junk bonds” or “high yield debt” are corporate bonds issued by companies with a shaky or un-established credit history. Naturally, anyone lending their money to this type of company should expect a very high yield to compensate for the additional credit risk. Is that happening?

This past week, the yield on the Barclays U.S. Corporate High Yield Index (NYSEARCA:JNK) fell below 5% for the first time ever. Are sub 5% yields adequately compensating bond investors for the type of credit risk packed into junk bonds? Most people buying junk bonds at today’s yields have no understanding of just how dangerous and volatile these types of bonds are.

Going Too Long on the Yield Curve
Another segment of the population is piling into long dated bonds (20+year maturities) to get more yield. Unfortunately, prices for long-term bonds and Treasuries (NYSEARCA:TLT) more vulnerable to interest rate spikes. This leaves unsuspecting people open to a world of hurt.

Our view of long-term Treasuries is as a short-term or temporary haven and nothing more. When stock prices finally have their long overdue correction, Treasury prices (NYSEARCA:UBT) will spike, creating a short-term trading opportunity. 

Betting on Shaky Countries
Here’s another sign of lunacy in the bond market: Frontier market countries (NYSEARCA:EMLC) are raising billions of dollars faster than the flick of a switch.

Bloomberg reports that, “Rwanda sold $400 million in dollar-denominated 10-year bonds at an annual yield of just 6.87%.”

Although Rwanda has grown rapidly, around 50% of the population still lives below the poverty line. Approximately 90% of its workforce works in the fields. “As a result, the country is heavily dependent on foreign aid, which covers about 10% of gross domestic product.”

It’s a sure bet that when the next credit crunch arrives, nations like Rwanda will default on their debt. Heck, even developed countries like Japan (NYSEARCA:FXY), Spain (NYSEARCA:EWP), and Italy (NYSEARCA:EWI) have the same acute risk!

High Income, Lower Risk
There are much better strategies for generating high income than three examples you just read about. Selling covered call options is just one example. 

Since the beginning of the year, our ETF Income Mix Portfolio has generated over $3,000 of monthly income. How do we do it? Instead of chasing yields in high risk bonds, we use a lower risk strategy by selling covered calls. It allows us to still collect dividends on the underlying ETFs and to cushion our portfolio against market declines. 

CommentsAdd Comment

Jay said on May 15, 2013
  Beth, Ron got me interested in covered call writing not terribly long ago. I have since read three books on the topic and made it a staple part of my income replacement strategy as I am recently retired.

It is not perfect - nothing is - you tend to under perform straight up markets like the past few months. But it is an income producing engine to significantly enhance the yield from a stock/ETF portfolio you would own anyway. Best of luck to you...-jay
 
 
Ron the Editor said on May 12, 2013
  Hi Beth,

Here's a good primer on the basics of covered calls. (just copy & paste link below into your browser) It's from the Options Industry Council:
http://www.optionseducation.org/strategies_advanced_concepts/strategies/covered_call.html

Take care,
Ron the Editor
 
 
Beth said on May 12, 2013
  What are covered call options & how are they making money? I wouldn't want to jump in till I understood. Thanks!
 
 
FERRIS said on May 10, 2013
  True graberk. Look at what happened to high yielding REIT and junk bonds in 2008. Auntie Jen and Uncle Jim got creamed. Can it happen again?
 
 
graberk said on May 10, 2013
  Don't forget mortgage REITs and business development companies or "BDCs." There's a lot of money chasing these two speculative asset classes too. Good article.
 
 
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