Bob Carlson

Bloomberg television is promoting a show airing Thursday in which some prominent investors apparently say that buying subprime mortgages is the best investment for 2012. The show apparently includes people who shorted mortgages and housing in 2007 or thereabout now saying they are buying mortgages. It’s not a bad investment, but they’re a little late. at Retirement Watch, we’ve had our readers invested in mortgage bargains for several years. We’ve been recommended bond funds managed by Jeffrey Gundlach that loaded themselves with mortgage securities purchased from distressed sellers as the market collapsed in 2007-2009. The securities were purchased at low percentages of face value and have generated cash at very low risk to shareholders for several years. I suspect these prominent investors on the show bought their mortgages a while back and are talking about them now because they’re finished buying.

A bull market mantra was “cash is trash,” meaning that investors shouldn’t have any of their portfolios in cash when stocks are rising by double digits each year. That was the mantra even when money market funds were yielding 4% and higher. Now, there’s an even stronger argument to limit your cash holdings. Money market funds charge fees, and in not a few cases those fees are higher than what the same mutual fund company charges on some of its equity funds. This piece in Fortune for example demonstrates that Fidelity’s fees on the money market fund offered to 401(k) plans are about three times the fees charged on its S&P 500 Index fund for 401(k) plans. The stock fund has about a 1.9% dividend yield, compared to the 0.10% yield on the money market fund.

Of course, there are differences. The index fund is far more volatile in value than the money market fund. Also, managing the index fund probably takes considerably less work than managing a money market fund in today’s climate. Fees matter, but they aren’t the only thing that matters. When you have strategic or practical reasons for holding cash in a money market fund, the fees are the cost of meeting your goals. In the March issue of Retirement Watch I discuss the options for people who seek higher returns on their safe cash without significantly increasing their risk.

A Fidelity spokesman responded to the criticism by highlighting the research costs associated with money market funds, especially amid European debt worries. “Fidelity has long made a significant investment in its money market research capabilities,” says spokesman Adam Banker. “Fidelity’s research team makes its own independent minimal credit risk determinations on every issuer or security in the money market funds.”

Closed-end funds are one place investors are looking to earn higher income. They’re also paying up for this yield and taking on much higher levels of risk, risks they might not realize. Bloomberg recently surveyed the market and found investors are paying hefty premiums for yield. Six of the 10 closed-end funds with the highest premiums are from PIMCO, and one carries a hefty 66% premium. That means an investor who pays shares of the PIMCO High Income fund is paying $1.66 for each dollar of assets owned by the fund.

Closed-end funds, which sell a fixed amount of shares to raise money for investments and then trade on an exchange like stocks, on average pay out 6.7 percent, beating dividend yields offered by open-end mutual funds, stocks in the Standard & Poor’s 500 Index and bonds, in part because they can use debt to boost returns for investors. While a premium signals confidence in the manager, buying the funds for more than its underlying holdings are worth can increase the risk of losses if the share price declines.

The Fed’s zero interest rate policy causes safety-first, income-seeking investors to consider investments they wouldn’t have paid any attention to a few years ago. One of those is the derivative CD, which goes under a number of different names. Basically it promises to give you a return, if any, tied to an investment or index. The return might be tied to a stock market index, gold, or almost anything else. If there’s no return, your principal is guaranteed. And since the CDs are sold by banks, they are insured by the FDIC.

These CDs are complicated, have high fees, lack liquidity, and many of the buyers probably don’t understand what they’re buying. The Financial Industry Regulatory Authority (FINRA) recently issued an alert about them. Bloomberg has a detailed look at these very popular investments ($25 billion of sales annually). They’re very profitable for those selling them, but maybe not so good for the buyers. Derivative CDs have their purposes and can be appropriate for some investors. But you have to understand that they aren’t higher-yielding alternatives to regular CDs. The yield isn’t know in advance and could be either higher or lower than what you’d earn on a regular CD. You also aren’t likely to be able to change your mind before the end of the contract.

“They are hugely profitable for the issuers, much more profitable than typical CDs, and they are poorly understood by retail investors, who will not be able to figure out how much profit the issuers are making,” said Frank Partnoy, a University of San Diego law professor and former Morgan Stanley (MS) derivatives trader. “The institutions that are selling them might as well be marketing CDs whose value depends on which team wins the Super Bowl.”

Sales of the investments may total $25 billion a year, Sean Gordon, who oversees distribution of market-linked CDs in the U.S. at Barclays Plc (BARC), said in a December interview. Banks sold a record 1,271 of them last year, according to StructuredRetailProducts.com, a database used by the industry, with some offering potential annual returns of as much as 24 percent by tying rates to everything from gold to Brazil’s real.

Bank revenue from the investments more than tripled to $99 per million dollars in retail deposits in October from $30 in January, according to Kehrer-LIMRA Research compiled from approximately 30 lenders, including Wells Fargo (WFC) & Co. and SunTrust Banks Inc.

The SEC has been trying to “fix” money market funds since the crisis of 2008. Then, one major MMF was liquidated and returned less than full value to its shareholders. (A fund sponsored by The Reserve Funds.) Others were supported by their parent companies, and ultimately the federal government guaranteed the funds for a period of time. The SEC apparently is ready to come out with several proposals that will increase the security of shareholders but also will reduce the already puny yields and limit the liquidity of the funds. The changes mean a money market fund will no longer be the checking account substitute that money investors have come to expect.

The SEC’s first proposal would call for money funds to abandon their traditional $1 share price, adopting a so-called floating net-asset value. Industry executives have fought the idea since it was floated in January 2009 by a think tank headed by former Federal Reserve Chairman Paul Volcker.

The second plan would require funds to build a capital cushion designed to absorb potential losses and hold back at least 3 percent of client redemptions for 30 days.

The Federal Reserve has a zero interest rate policy and has had it for several years. But is that the real reason interest rates on investments stay low? This web post argues that investors are the real reason they can choose only from low yields. Yields on certificates of deposit rise and fall with the flow of money into CDs. When households want safety they pour money into CDs, and that brings down rates. Take a look at the charts. They indicate investors are scared and they’re willing to settle for low yields.

Basically, the yields on CDs undulate in perfect rhythm with the proclivity of people to put money in savings deposits. As more people want to put money in savings deposits (red line declining) yields fall, which is exactly what you’d expect. As fewer people are inclined to deposit money in banks (red line rising) yields rise.

Want to know why yields are lower than ever before? It’s because people are putting money in banks like never before.

The President came out with a new proposal for helping homeowners who are underwater or have other problems refinancing their mortgages. There’s also a plan from the government agencies that own a lot of foreclosed mortgages to sell these to investors for use as rental homes. How do these plans affect owners of mortgage securities and especially owners of my recommended DoubleLine Total Return Bond?

Jeff Gundlach, manager of DoubleLine, says he’s been planning for the likelihood of such plans. He warns investors in Ginnie Mae (or GNMA) funds that they will likely be hurt if the President’s plan becomes law. The refinancing will lead to a lot of prepayments that they’ll have to re-invest at today’s lower yields. He thinks the Ginnie Maes, which did well last year, are overvalued and he won’t own them. He says over the last six months he’s purchased mortgage securities that reduce the fund’s exposure to refinancing by about 50%.

“I’m astonished people are fighting the will of the U.S. government,” Gundlach, founder and chief investment officer of Los Angeles-based DoubleLine, said in a telephone interview. “Investors are being insufficiently compensated,” especially given the risk of higher prepayments.

Ginnie Mae bonds are trading 2.4 cents on the dollar higher than Fannie Mae debt, more than double the difference over the past five years, making them more susceptible to price declines, according to data compiled by Bloomberg. Fed Chairman Ben S. Bernanke is attempting to accelerate refinancing by holding short-term interest rates near zero, buying mortgage bonds and advocating for changes to government housing policy. Obama said this week he plans to send legislation to Congress to help more homeowners take advantage of record-low borrowing costs.

This summer the rating firms are likely to change their rating methodologies over the summer in response to Dodd-Frank mandates, and that is likely to generate significant downgrades for some tax-exempt bonds. So said Peter Hayes, head of municipals at BlackRock, at a conference of the Investment Management Consultants Association. Tax policy also could change over the next year or two, and investors need to keep that in mind when analyzing their portfolios. Hayes believes there are good opportunities in tax-exempts for a while, but investors need to monitor these two threats and keep them in mind.

The spreads between higher-rated municipal bonds and less-than-investment-grade ones are “dramatic,” so a severe downgrade could have a big impact on pricing, Mr. Hayes said.

Investors in municipal bonds also will have to consider the effect of likely tax policy changes, which should become clearer in the second half of the year. The ultimate outcome, though, will be decided by the outcomes of the presidential and congressional elections, Mr. Hayes said.

There’s been a lot of big news from global central banks over the last month or so, but the events have one consistent effect: Traditional savers and investors are in a lot of trouble. To support global economies and offset the deleveraging in the developed world, the central banks have decided to drop any restrictions on their money creation. Since 2008, the Federal Reserve and the European Central Bank have had stop-and-go money creation policies. They’ve decided that isn’t going to be enough in the face of the growing sovereign debt crisis in Europe. The ECB made clear it no longer would have restrictions on money creation with its willingness to make three-year low interest loans to European banks backed by virtually any collateral. The Fed already announced it would facilitate loans to European banks through the ECB. On Wednesday the Fed went a step farther. It plans to keep short-term interest rates low at least through mid-2014. It’s also going to try to keep long-term rates low to make mortgages affordable and help the housing market.

The Fed’s made no secret that it plans to support the U.S. stock market. It believes increasing household wealth through higher asset prices will increase confidence and generate more economic activity. I’ll have more to save about this in future issues of Retirement Watch, especially its implications for investors. I’ll also discuss it in the free webinar coming Feb. 1 at 3:30 p.m. eastern time. Spaces are limited. To reserve your place in this free webinar, contacting TJT Capital at info@tjtcapital.com or 877-282-4609. You can review past webinars at www.tjtcapital.com.

That means U.S. investors starved for yield will have to continue their search for income by extending maturities or durations of their fixed-income holdings, or putting money in riskier, higher-yielding securities, said Dean Junkans, chief investment officer of Wells Fargo Advisors and Wells Fargo (WFC) Private Bank, which are units of Wells Fargo & Co.

“There’s not an easy answer for retirees,” said Junkans, who’s based in Minneapolis. “Don’t be lulled into the belief that buying intermediate Treasury-type products or strategies at these low, low interest levels are risk free.”

I always warn people against using rules of thumb and other easy tools to make decisions. A good example is interest rates, bonds, and deficits. At the beginning of 2011, most analysts were convinced interest rates in the U.S. would rise. They had to rise, people reasoned, because the U.S. deficit was so high that it would push interest rates and inflation higher. But the opposite happened. That’s because the economy and markets are complex. There are many factors at work, so you can’t rely on a simple A+B=C formula.

John Makin of the American Enterprise Institute explains why interest rates remained low in 2011. He identifies three factors: inflation remained under control; economic growth was less than expected; and investors put a premium on safety. In fact, while the theory that high budget deficits cause higher inflation and interest rates seems sound, there hasn’t been a strong correlation between those factors in the U.S. What’s likely to happen to interest rates in 2012? Here’s a tease:

Looking ahead, 2012 may see fewer risk events shocking investors than occurred in 2011. The recent rise in stock prices suggests that some investors are hoping for such an outcome. But the persistence of low interest rates on high-grade government bonds suggests residual caution among many investors who apparently are more worried about weaker growth and volatile credit risks among low-rated government bonds than they are about higher inflation.