Further to my blog: Stay Ready, Be Patient, I have a few more points to make about credit risk, interest rates, bonds, and high yield mutual funds – but first, some irony.
On May 28, 2012 the aforementioned blog asked rhetorically, "Wouldn’t it be interesting if they [Greece and Spain] struck a new deal with [the IMF]? – China and Russia the big-players there."
And then three days later, today, May 31, 2012, this headline crossed the wire on the Wall Street Journal on-line: IMF Begins Internal Talks Over Spain Loan.
Indeed, the money game just got more interesting – the specter of a third world currency one step closer (see: 3 Pointer).
The money game I refer to is being conducted by governments of major markets in the civilized world; they are the only ones able to print legal currency, and they can also issue bonds to raise capital. With bonds, low risk (a.k.a. safety) equates to low interest rates in the future. That’s how credit risk is related to interest rates.
For example, the United States of America has never defaulted on a debt and for that reason is widely considered to be the "risk-free" rate of interest – generally known as, the lowest interest rate found on the bond market. As an FYI, the 10 year U.S. bond is around 1.5%.
Germany’s recent zero percent coupon bond screams one thing: Your money is safe with us. Perhaps the most stable and profitable market in all of Europe, Germany is using its regional clout to attract local money cheaply so it can relend it at higher interest rates. That profit, I surmise, is a benefit awarded to regional fiscal strength.
And much to the contrary, high credit risk equates to higher rates of interest. A country with a dying economy that can’t afford itself, like Spain and Greece, can never justify zero percent interest rates. The credit risk is too high; lenders require more compensation to lend to their situation. That’s why Spain’s interest rates are on the rise. See the chart below (source noted).
So Germany is issuing certain bonds at 0%, the U.S. has some around 2%, and Spain is more than three times that at 6%. Also note that these interest rates are in a relatively low inflation environment. Persistent printing of currency will ultimately cause inflation because it cheapens the dollar, therefore, requiring more dollars to purchase the same goods (see: In Real Terms).
Inflation, sure to arrive in force as a result of sloppy money policy, will drive all of these interest rates higher. So if countries can’t afford their debt payments in this historically low interest rate environment, they don’t have a chance of making timely payments under future higher interest rates. And then Europe really has a problem – which will instantly travel across the pond.
For instance, when interest rates rise, so will failures and defaults. This puts "high yield" mutual fund owners at the epicenter of correction because buried in these massive pooled funds are, without a doubt, high risk loans to the likes of Greece, Spain, and/or Portugal etc. Like higher interest rates, defaults will cause bond values to fall and a wide scale deterioration of invested capital and/or principal. High yield mutual fund owners should take special note of this dynamic and allocate their portfolios appropriately!
Some fund owners are under the false impression that high-yield fixed income funds are a "safe" bet because they’re bonds or backed by governments. So not the case. High-yield bond funds are comprised of high-risk bonds issued by borrowers most likely to default. While those countries might not fink on the entire loan, a debt restructuring usually includes some portion of forgiveness (a.k.a. loss for lenders.)
That said, be very careful with your bond and fixed income allocations in this kind of environment, where monetary and fiscal incompetence is demonstrated daily. The possibility of loss in principal and falling valuations is very high. Consider high-yield mutual funds a high-risk proposition.
You should also know one more thing about the worldwide money game: for some sad, strange reason the U.S. government appears to be hell-bent on losing it. They continue to make the same mistakes made by their European brethren by continuing to avoid sound money and spending policies. The U.S. is getting out-maneuvered at every turn (see: Management Deficit Disorder) and it’s hard to watch.
But if you’re an independent investor, it’s a train wreck that must be witnessed. It’s the only way to know the score.