Markets distill human interaction. Within manias and crashes act the opposing human flaws of greed and fear. This dualism will explain market behavior as long as there's a bid and an offer, but it strikes me that a third human condition is at work today. More than fear or greed, need is leading income investors astray.
Money market accounts return zero. Longer-dated Treasuries and Ginnie Mae pass-throughs yield about 4%. These taxable income streams fall well short of the needs of income investors and defined benefit plans. Taking the first orthodox step into credit risk doesn't help much: investment-grade corporate bonds offer on average a 4.5% yield, a glib statistic forgetful of defaults. To add insult to injury, remember the forthcoming surtax on unearned income, likely a harbinger of more to come.
Faced with the anemic top lines of safer havens, the needy feel forced to embrace risk. So they speculate in risky plays on junk bonds, equities and hedge funds – and cover their ears and hum. They pray that default and balloon-refinance risks make only a small dent in the yields of below-investment-grade bonds, already trading at mediocre credit spreads by historical standards. High yield buyers have even swallowed covenants in new issuance as disadvantageous as those of 2006-2007 paper. Likewise, the needy ignore the overvalued fundamentals and de minimis dividends of stocks. After all, in theory, equity has unlimited upside. And hedge funds. Yes, hedge funds are opaque, but that's viewed as a virtue in times like these. In a world where analyzable investments fail to get the job done, opacity invites the buyer to dream.
These risky strategies perform best in times of growth and inflation. That day may come. Washington may indeed try to stoke inflation to goad consumption and, truth be told, to debase the immense unfunded liabilities of the U.S. government. But the inflationists are thinking too many moves ahead on the chess board. Before a possible inflation end game, I believe we must counter further attacks in the deflation middle game. If I am right, nervy gambits for income will end in the heartburn of principal destruction.