Many American investors bought Puerto Rican bonds over the past five years as we all searched desperately for yield in the face of the Federal Reserve pushing interest rates down to historic lows. Normally, investors understand that higher yields come with greater risks. However, during the past six years of extraordinary interventions by the Fed into all sorts of financial markets, many investors may have decided that those higher yield investments weren’t really all that risky.
Partly, they were deluding themselves. Clearly, as much as investors may have been pushed into these riskier waters in order to preserve at least some of the income from their investment portfolios, they should still have understood the tradeoff—that they were accepting more risk in order to gain more return. Yet, partly, they thought the Fed had their backs. After all, the Fed had saved a lot of other people and other investments and seemed to be pumping money everywhere. Plus, how could things go bad when yields were so low? Projects that were risky before were surely safer now with the ability to tap debt markets at such low cost. Right?
As rates begin what is likely to be a very slow, very long path back to normal levels, investors would do well to remember that one outcome of rising rates is that capital allocation will move back to more normal patterns. As safer alternatives begin to sport higher rates of return, fewer dollars will be willing to take the risks involved in some of the higher yield vehicles many of us have made part of our portfolio over the post-recession period. That means some of those risky investments that looked “safe enough” for the last few years might suddenly find themselves cash-starved.
Puerto Rico’s problems, while not entirely or even mostly related to the long-expected rise in interest rates, may serve as a much-needed wake up call to investors that the times are changing. As rates rise, capital will move back toward safety and the risk premium demanded of higher risk projects is likely to increase.
Already, the spreads between Treasury yields and both general corporate bond rates and high yield bond rates have increased significantly. The high yield spread is at almost 7 percent, meaning investors now want 7 percent more return to put their money in high yield bonds compared to the return expected from Treasuries. While that is a long way from the recession-peak of 22 percent, it is also pretty far from the post-recession spread low of about 3.5 percent.
Rising interest rates will be good for the economy in a number of ways, including that they will encourage a better allocation of capital across our economy. However, investors must be aware that this reallocation is going to happen (and is already underway). Without the backstop of cheap money that was available because it had few other alternatives, a number of investments that performed well and looked reasonable over the past five or six years are rapidly become riskier. Rising yield spreads mean that the return is rising to try to compensate for that risk, but individual investors will need to make their own assessment of whether the extra return being offered is sufficient.
My guess is that investors will be slow to adjust to new realities (we usually are) and that many of these riskier investments are actually worse than we think. Instead of getting higher returns through greater yields, investors can end up with capital losses thanks to either falling bond prices or even defaults. Puerto Rico may just be the first indication that sometimes the return on a risky investment is much less than you expected.
Pedro Cuellar, marketing director for Puerto Rico Industrial Development Company, spoke with a guest during the Department of Commerce’s SelectUSA Investment Summit in March 2015. (Photo by Kris Connor/Getty Images for Puerto Rico Industrial Development Company)
Puerto Rico Bond Defaults Early Reminder To Investors: Return Does Not Come Without Risk
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