Your Complete Guide to Index Investing with Dan Bortolotti

More Promises of High Yield Without Risk

2011-03-18T21:44:47+00:00August 19th, 2010|Categories: Bonds|8 Comments

Earlier this week I argued that savings accounts and GICs are still the best vehicles for short-term savings, because higher yield comes with higher risk. I thought that was an obvious point, but it seems that even the venerable Kiplinger’s Personal Finance has forgotten this basic truth of investing.

The September 2010 issue of the popular magazine features a cover story called 10 Great Mutual Funds That Deliver High Income, by senior editor Bob Frick. The article itself makes no outrageous claims, but in a podcast interview about the piece (available at iTunes), Frick takes a journey into Fantasy Land. After lamenting the low yields of US Treasuries, and the likelihood that they will fall in value in the near future, Frick recommends a Fidelity fund that invests in emerging market bonds. “You just cannot ignore a fund that is going to pay you 12%,” he says gleefully. Going to pay? The fund in question has posted excellent returns in the past, but no bond fund is going to pay any guaranteed return. For all Frick or anyone else knows, the fund might lose 12% or more next year.

Maybe that was a slip of the tongue, I thought. But then he kept up this nonsense. “When you look what’s in it, you see it’s got the sovereign debt of Russia, Argentina, Mexico, Indonesia, and you think, ‘That can’t be so hot.’ But it also has Brazil and some other developing countries. The thing that people don’t realize is that these countries often have more fiscal discipline than the US, the UK and Western Europe. So they pay their bonds off, and they pay them off on time… Maybe if you just invested in Russia or Indonesia it would be dangerous, but it’s spread over all these different countries, so you’ve got this great diversification, and you’ve got this income that rivals the return of the stock market. And it’s more dependable. It’s like having your cake and eating it, too!”

OK, let’s get this straight. The senior editor of Kiplinger’s Personal Finance believes it’s a given that emerging-market countries “pay their bonds on time.” And therefore he believes that investors in this fund can expect a yield that rivals the return of the stock market with less risk. Perhaps he’s also built a perpetual motion machine or achieved cold fusion, too.

I’m not going to defend the fiscal policies of the US, but I think it’s fair to say that if I buy a US Treasury note, I’m going to get my interest payments, and I’m going to get my principal back. Frick magnanimously concedes this point in the interview when he says, “they’re still the safest investment in the world, blah, blah, blah.” That’s a direct quote, by the way.

How can Frick so casually brush aside the differing risks of emerging-market bonds and US Treasuries? Several of the countries he names have defaulted on their sovereign debt in the past, and they may well do so again. That’s why they yield more. And when one country has a financial crisis, investors worry that its neighbors will follow, and their bonds can lose value, too. So diversification does not necessarily offer any protection. Witness the Latin American debt crisis that peaked in the early 1980s, the Asian contagion of 1997, the Russian default of 1998, the Argentine economic crisis  of 1999–2002. This is hardly ancient history.

Emerging market debt may well be a good investment, but its potential returns are commensurate with the risks. When Frick says it’s “having your cake and eating it, too,” he’s implying that the added yield is free. That is irresponsible journalism and terrible investment advice.

Blah, blah, blah.