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Low CD rates fueling risky bonds?

By Claes Bell, CFA · Bankrate.com
Monday, March 7, 2011
Posted: 2 pm ET

Historically low rates on certificates of deposit could be fueling the next junk-bond bust.

As I was working on an upcoming story on some of the perils of investing in high-yield, high-risk foreign bonds, one thing that kept coming up in the interviews was how ultralow CD rates seem to be pushing Americans into riskier investments.

I think there's some truth to this. There's a pretty big slice of the American investing public made up primarily of retirees that, for many years, have depended on interest earned from deposits to supplement their Social Security income.

Unfortunately, since the federal funds rate dropped to essentially zero in 2008, these savers have been reluctant to roll over the principle from maturing long-term CDs paying upward of 5 percent into new ones paying 2 percent, because doing so would lock in an interest rate so low it would reduce their income to unsustainably low levels. You can see this in the Federal Reserve's figures for U.S. deposits in "small-denomination timed deposits," their technical term for CDs. Those figures show a massive outflow of capital, with total deposits falling from $1.3 trillion to $895 million since September 2009.

Deprived of the virtually risk-free way to get the interest income they need, normally cautious CD investors may be putting some of that money into high-risk junk bonds. A recent Fitch Ratings report found 2010 was a record year for junk bond issuance and yields are at record lows thanks to high investor demand, and I'd wager part of that demand is from individual investors desperately seeking yield.

But if you're a CD investor driven by low yields into venturing into the world of junk bonds, I can't stress enough the need for caution. As Kent Grealish of Quacera Capital Management pointed out to me in an interview, we've seen this movie before. It stars a junk-bond king named Mike Milken, who made a truckload of money selling junk bonds to retirees disgusted with CD yields that had fallen from the teens into the single digits by the mid-'80s. Many of those bonds eventually imploded, leaving thousands of retirees to live out their remaining years in poverty.

I'm not unsympathetic to the motivations of retirees stretching for a decent return. For many retirees, social security isn't enough to maintain the standard of living they worked their entire lives to obtain, and so they rely on regular yields to meet their financial obligations. But I think it would be a terrible shame to lose one's life savings to junk bonds just as CD rates finally look to be rising again.

What do you think? Are low CD rates pushing people into risky investments?

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