The Law of Unintended Consequences, Part 657

One of the scariest aspects of the credit boom and bust cycle we’re still dragging ourselves through was how widespread the bad bonds were.  In hindsight, it’s easy to look back and say “What the hell was that pension fund manager doing buying 2nd-lien mortgage debt products?”

But there were three reasons for the madness:

• Everyone else was doing it!

• It was rated AAA or AA so what’s the big deal?

• Greenspan had driven interest rates down and held them down making it impossible for managers to meet their interest obligations without dipping a toe into the exotic.

That third reason got a whole lotta folks in trouble when all they wanted to do was earn some necessary income in an absurdly low-rate world.

Thus, the Law of Unintended Consequences was that there was unnatural demand for bad bonds amongst the managers who were supposed to be the most conservative and prudent.  Greenspan certainly didn’t mean for this type of yield-chasing when he dropped rates and kept them low through 2003, but that’s what “unintended” means.

I remind you of all this because the Law of Unintended Consequences is hard at work right now in this era of Zero Percent Interest Rates Forever.  Finra issued an alert yesterday warning investors about the danger of chasing yield into structured products with sub-surface risks and lockups.

And hopefully somebody pays attention because I gotta tell ya, brokers from coast to coast are jamming as much of this stuff down people’s throats as they can, the pitch is so easy a child could sell it.  Some stats from Financial Planning Magazine:

High-yield bond funds had $75 billion in new sales in 2010. Floating-rate fund inflows grew from $15 billion in 2008 to $60 billion in April 2011, and sales of structured products increased from $33 billion in 2009 to $54 billion in 2010.

Between this stuff, the private REITs and the equity-linked annuities that are everywhere you look now, I fear that individual investors are once again marching themselves into a black hole in the name of yield.

In my practice, I’m using high dividend-paying stocks and MLPs to try to fill the income gap and make up for what bonds aren’t giving me.  Sure, I’m taking risk too, but it’s the “devil I know” type of risk that can at least be quantified.  Give me market risk over unknown product risk any day of the week.

Source:

FINRA Warns of High-Yield Alternative Investments’ Risk (Financial Planning)