Lured into “The Optimistic Unknown”

What does the fixed income side of your portfolio look like these days? What kind of Frankenstein Funds, leveraged fixed income plays or “structured products” have been shoveled into it as a result of ultra-low rates and the siren song of “alternative yield”?

You might be surprised once you take a glance.

This kind of thing happens to everyone, there’s no shame in it.

The worm is turning now and rates have been rising since last summer. Many forecasters see the ten-year treasury yielding north of 3.5% by year-end 2014. This leads to dislocations and a reversal of flows into many niche areas within the investable markets that would never have gotten as popular if not for the Fed-driven distortions of the post-crisis period.

It may be a good time to have a rethink some of the bizarro substitutions for plain vanilla Treasurys, munis or investment grade corporates you might be holding onto. Do they make as much sense in a post-ZIRP world or during inning two of the stimulus taper?

The below comes from Chris Goolgasian, CPA, CFA, CAIA who is the Head of Portfolio Management, Investment Solutions Group of State Street Global Advisors. You can tell by the amount of acronyms after his name that he knows his stuff 😉

Anyway, Chris calls this herding into new products or strategies “The Optimistic Unknown” – wherein people decide they have to do something unfamiliar and assume it will work out fine because they haven’t thought through the consequences…

This is one of the legacies of today’s Central Bankers. They may not have created goods or wage inflation yet, but their actions certainly have created asset inflation. The Central Banks have distorted the risk-free rate to such a degree that some investors have embraced what we call “the optimistic unknown”. That is, they’ve been lured into higher-yielding instruments today, even though they don’t fully “know” the underlying construction or potential risks, on the hope those investments don’t falter tomorrow. This sort of behavior has a number of ramifications, including:

1. The marketplace will create more products to meet the demand.
2. As the most likely buyers are less familiar with these types of investments, they are, therefore, less sure of themselves and potentially may flee at the first sign of danger.
3. The lack of understanding will end badly in some cases and as with all communication snafus, the seller of the product will be blamed.

Chris’s note cites some obvious examples of this sort of thing:

* MLP’s: in less than three years, the largest Master Limited Partnership ETF in the industry has grown from $600 million to over $6 billion in 2013.

* Bank loans: mutual fund assets have grown from $14 billion in 2008 to $114 billion in 2013.

* Emerging Market debt: mutual fund assets have grown from $11 billion to $75 billion since 2008.

These are just a few examples, but there are many more including the growth of “business development companies” and the growth of “credit” hedge fund strategies, both of which tend to offer attractive yields.