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No miracle investment earns large returns without risk

July 7, 2008

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Want to find a safe investment that will pay you more than CDs or Treasury bonds?

Welcome to the club. Financial advisers say they are busy listening to clients who are afraid of stocks but are tired of earning less than 4 percent on safe investments while gasoline and food prices soar.

But if you think your adviser is going to find you a juicy, no-risk delight, you have just flunked Investing 101.

Risk vs. reward

The immutable truth of investing is that you get two choices as an investor: You either keep your money fairly safe and earn relatively little interest on it, or you tell yourself honestly that you will take a chance with your money - risking it on an investment that potentially could pay you more than something safe, but with the full knowledge that "risk" means you can lose money as well as make it.

The pros talk about it as the choice between "risk and reward." The reward for investing in stocks has been a 10.4 percent average annual return since 1926, even though the high-risk investment has resulted in losses in excess of 30 percent in some years and about 20 percent since early October.

The reward for feeling safer in long-term U.S. government bonds has been a 5.5 percent average annual return for the past 82 years, although there have been some losses when interest rates have been climbing sharply. The worst was a 9.18 percent loss in Treasury bonds in 1967, according to the Ibbotson 2008 Classic Yearbook, which is published by Morningstar Inc.

If an investor had put a dollar into the stock market at the end of 1925, he would have had $3,246 at the end of last year - the reward for risk-taking. A person who put the same dollar into U.S. government bonds at the same time would have had $78 at the end of 2007.

High-yield bonds

Cautious investors who can't stomach the shocks of the stock market often stay clear of stocks and cling to bonds. But at times like the present, with the Dow Jones Industrial Average hitting bear market territory last week and bonds paying less than the cost of inflation, people start to become impatient.

So financial advisers are hearing from clients wondering if they should give high-yield bonds a try. The answer: If you are on a fixed income and can't afford a loss or if you are afraid of stocks, you should think carefully about relying on high-yield bonds - even if they come from companies with household names.

High-yield bonds can be dangerous because they are issued by companies that are in weak financial condition. They pay high yields, or high interest, to entice investors to take a chance on a company that could go bankrupt and not be able to pay back bond investors.

Like stocks, high-yield bonds often lose value when companies have trouble selling products during recessions. In 1990, for example, as the Russell 2000 index of small company stocks plunged 19.5 percent, the Lehman high-yield bond index dropped 9.6 percent, according to Ibbotson chief economist Michele Gambera.

So investors in high-yield bond funds would have lost money. People with individual high-yield bonds - such as those from General Motors - risk losing everything if a company goes bankrupt. Last week, a Merrill Lynch analyst raised that possibility for the troubled auto company.

This year, the average high-yield bond fund has lost about 1.8 percent, according to Lipper Inc.

Not worth it

Even bond fund managers, who avoid risks, frequently buy some high-yield bonds and sprinkle them into funds with safer bonds. The approach sparks up returns for bond fund investors. Yet in the current environment, U.S. high-yield bonds are not behaving as expected, and some bond fund managers are reluctant to buy them.

Derek Young, manager of the Fidelity Strategic Income Fund, said that in a recessionary period it would be common to see yields on the risky bonds about 10 percentage points above Treasuries, which means today the average high-yield bond should be at about 14 percent.

But, instead, he said, the yield is only about half that because investors have been buying the bonds recently in the search for yield.

Young said he will be reluctant to buy U.S. high-yield bonds unless the yields climb more. He notes that the risk during recessionary periods is relatively high, with about 10 percent of high-yield bonds defaulting.

In other words, Young doesn't think the risk is worth the reward.

Recently, risk in high-yield bonds has been relatively low. The default rate has been about 2 percent annually, but Young notes that Moody's is estimating defaults to rise to about 5 percent or 6 percent as the economy encounters the threats of slowing growth, high energy and other prices along with a credit crunch.

Last week, with oil over a record $144 a barrel, Standard & Poor's said even companies that explore for oil and produce energy are under financial pressure because they are paying dearly for the energy they need to operate. And in the current credit crunch, lenders are more cautious about extending loans to companies under stress.

Standard & Poor's analyst Michelle Dathorne noted, "Companies rated below investment grade face tighter credit terms and, in some cases, must prepay for crude." Companies that issue high-yield bonds are considered "below investment grade."

Overseas investing

At a Morningstar conference in Chicago recently, bond fund managers Daniel Fuss of Loomis Sayles and Curtis Mewbourne of Pimco said the relatively low yields on high-yield U.S. bonds had encouraged them to look outside the U.S. for better-yielding bonds.

Although Asia has been developing quickly and Latin America has been enjoying the world's thirst for oil, the emerging market bonds are not without risk, either.

Investors are just getting paid more for taking the risks.

"The biggest risk would be if the credit crunch goes global and can't be contained, if it goes to China, Brazil and India and causes a real contraction (in economic growth) there and low commodity prices," Mewbourne said.

Yet Mewbourne isn't forecasting that. He, along with Fuss and Young, is concerned about rising inflation.

Consequently, while they are reluctant to buy U.S. high-yield bonds, they are also cautious about U.S. TIPS, or Treasury inflation protected securities. They don't think the inflation protection that's built into them now is adequate for the current rising-price environment.

With the combination of inflationary threats, a credit crunch, a fast-developing globe and slowing growth in the U.S. and Europe, Young said, "It's tough out there, to know where to be and where not to be."

-Gail MarksJarvis is a personal finance columnist for the Chicago Tribune and author of "Saving for Retirement without Living Like a Pauper or Winning the Lottery." Contact her at gmarksjarvis@tribune.com.

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