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There are no guarantees in life, but as of this writing it seems all but certain that Janet Yellen and the Federal Reserve Board of Governors will announce an increase in the Federal Funds rate from 0.00% to 0.25% sometime this week.

If they do, the increase will be the first since being lowered to 0% back in 2008, a strategy that has had a profound impact on how we spend, save and borrow money.  On one hand, debt has been cheap.  We’ve enjoyed 0% car loans, historically low mortgage rates and the like.  On the other, the ability to earn any kind of return in low risk vehicles like savings accounts, CDs and money markets has all but disappeared.

Risk and reward are inherently related.  When low risk assets offer no return, investors and fund managers, especially in the fixed income space, have no choice but to accept low returns or take on additional risk.  Dividend paying stocks have been popular, but this year has been a great example of how great dividends can come with corresponding risk of principal loss through stock price fluctuation.  In bonds, many investors, even those who traditionally stayed in shorter term, higher quality instruments, began to edge out to longer term, lower quality bonds.  Some took things to the extreme, which is acceptable, provided you were aware of the potential outcomes.  But those who may have purchased a fund thinking they were relatively safe assets only to find the fund manager stretching for the sake of yield could be in for a nasty surprise.

The recent news about Third Avenue Management’s decision to block investors from selling out of their Focused Credit Fund so that they can liquidate things in a more orderly fashion is not the case described above.  By all accounts, this fund represented the riskiest of the risky in the high-yield or junk bond class.  Nearly 30% of the bonds in its portfolio are rated CCC or lower and more than half of the fund was held in bonds with no rating.  Some of this debt was extended to small and mid-sized energy producers, many involved in the shale boom across the country.  These debts were seen as less risky when oil was at $70-80/barrel, but at $40 or less the strain of small producers to make their interest payments continues to increase, right at the time when the rate they’re required to pay begins to tick up in a rising rate environment.  It’s no surprise that investors have been selling out of this fund, but the rate has been alarming.  $979 million has been sold out of the fund over the last several months, making it impossible for the managers to generate the cash needed with no market for illiquid and poorly rated bonds.  As of last week, the fund lost 27% for the year with half of that coming in the last month.

The iShares iBoxx High Yield Corporate Bond ETF (NYSE: HYG) and the SPDR Barclays High Yield Bond ETF (NYSE: JNK) by comparison have around half of their holdings in BB- debt, 8% in CCC or lower and just 2% in unrated bonds.  While this means a higher likelihood that such funds can maintain liquidity, it doesn’t make it a substitute for cash or higher quality, shorter term debt.  In fact, both are down between 4-5% in the last month and between 3-4% for the year.

Those kind of losses in the bond market are one thing if it is part of a long term diversification strategy, but quite another if this is where an investor had put their mattress money in the hopes of eking out more yield than what’s available in Treasuries or a money market.

As we’ve written many times in this blog, it is our belief that investors are not adequately compensated for risk in longer duration, lower quality bonds.  We believe that risk is better shifted to stocks and that bonds should act much more like a safety net.  During periods where stocks do not perform well, it is important to have reserves available to cover any income needs from the portfolio or to take advantage of buying opportunities that down markets present.    We also believe it’s important to be invested in funds that you can rely on to stay true to their stated objective in order to ensure that models are in balance.  None of this guarantees smooth sailing in the sometimes rough waters of the market, but it does ensure a more disciplined investment strategy which, in all historic time periods, has provided for a more stable investment and planning experience.

As this is my last blog of the year, I wanted to personally wish all of our clients and readers a very happy holiday season and a safe, healthy start to your 2016!