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Combine investors’ hunger for yield with an industry-wide marketing push, and the result has been an inflating bubble of capital flowing into products focused on dividend-paying stocks and high-yielding bonds. In investing, desperation and herding are both dangerous, and when they occur together the danger is multiplied. (DARREN HAUCK/REUTERS)
Combine investors’ hunger for yield with an industry-wide marketing push, and the result has been an inflating bubble of capital flowing into products focused on dividend-paying stocks and high-yielding bonds. In investing, desperation and herding are both dangerous, and when they occur together the danger is multiplied. (DARREN HAUCK/REUTERS)

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Yield-starved investors headed for income bubble burst Add to ...

Important insights and moments of clarity can sometimes come from seemingly mundane observations. Investment history offers us some startling examples of this.

In 1929, Joseph P. Kennedy Sr. (the father of President John F. Kennedy) was a substantial stock market investor who managed to avoid the great crash of 1929-32. The 1965 biography Kennedy , by Ted Sorensen, credits Joe Kennedy with knowing that it was time to get out of the market in 1929 when his shoeshine boy began giving him stock tips.

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I’ve experienced a few of these moments of clarity myself. In 1999-2000 while checking the sector weights on the TSE 300 Index (predecessor to today’s TSX Composite Index) I was shocked to find that one company, Nortel Networks – a company that wasn’t even profitable – was accounting for over a third of the market cap of the entire TSE 300 Index. Already a doubter of technology stocks, this Nortel stunner hardened my resolve to avoid a sector that would later become the epicentre of the 2000-2002 stock market crash.

It’s happened again. In this case, a series of small events points to something bigger, warning of trouble ahead for a large group of Canadian investors.

For the last couple of years I’ve been inundated with market pitches and new product launches for income oriented financial products. I’ve spoken to other brokers about this and they all report the same thing. The mutual fund companies, the ETF providers, and investment bankers are all going full tilt putting out “income” products. The two main ways these vehicles go about providing the promised income are dividend paying stocks and high-yield bonds.

Last week, a mutual fund rep called to present his firm’s most popular fund, an income-oriented balanced fund. I took a look. The fund’s net assets stood at $1.8-billion on January 1, 2010, but had grown to $7.1-billion as of Sep 30, 2012. So, over 33 months the assets in the fund grew by 289 per cent. Only 25 per cent of that growth came from the gain on the fund’s investments, all the rest came from investors pouring new money into the fund. This is a story has been playing out across the financial services industry.

The cause for this clamouring for yield is not hard to find: Investors are starved for income and desperate for yield.

What Changed – Why the Craving for Yield?

In response to the financial crisis of 2007-09, global central banks lowered their short-term discount rates (like the Fed rate) to near zero, pushing down yields across the spectrum of safe securities. For instance, the yield on the 10-year Government of Canada Bond was just 1.32 per cent as of Nov 2, 2012. That means a retiree with a million dollars invested in 10 year Government of Canada bonds receives an annual income of $13,200 (just $1,100 per month) – and that’s before allowing for taxes and inflation.

Investors are ravenous for yield and getting desperate. Combine investors’ hunger for yield with an industry-wide marketing push, and the result has been a tidal wave of capital flowing into products focused on dividend-paying stocks and high-yielding bonds. In investing, desperation and herding are both dangerous, and when they occur together the danger is multiplied.

If history is any guide, this toxic mix will end in tears.

Joe Timmath is a financial advisor with Raymond James in Vancouver.

DISCLAIMER: The views of the author do not necessarily reflect those of Raymond James. This article is for information only. Securities-related products and services offered through Raymond James Ltd., member Canadian Investor Protection Fund.

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