Recovery Built on Retirees' Backs

Would you buy high-yield bonds, affectionately known as junk bonds, when investors are being squeezed to find extra income? Maybe not. On Oct. 12, 2002, the spread -- bond-market speak for the difference between the yield on higher-risk junk bonds and Treasuries with, theoretically, no default risk -- was 10.6 percentage points. By Jan. 26, 2004, that spread had shrunk to 3.4 percentage points.

I know corporate profits have been getting better. With low interest rates, companies have been able to repair their balance sheets to a degree. Yet the difference of 3.4 percentage points between the yield on a risky junk bond and on a U.S. government Treasury seems a rather skimpy return for assuming that extra risk.

According to the models run by Martin Fridson, editor of LeverageWorld, that Jan. 26 spread between riskless debt and junk was almost 2 percentage points less than it should have been to adequately compensate for risk.

Too Much Cash Is Chasing Yield

Investors, I'd argue, are taking on too much risk in their search for income. They're bidding the prices on some securities higher than what may be prudent. And that's likely to bring pain to at least some portfolios.

Finally, if the Fed is keeping interest rates at their current 40-year lows because of the way that the federal government calculates inflation, then isn't the stock market's high valuation more of a problem than it seems? (If inflation rates were higher, the Fed would, on past evidence, be more inclined to raise interest rates to head off an inflation problem.)

Low interest rates are the major justification on Wall Street for current stock prices. We hear this argument every day: Don't worry about statistics that show the current stock market is overvalued by past measures such as price-to-earnings ratios. This is a period of extraordinarily low interest rates. Adjusted for low interest rates, the stock market is reasonably valued.

Hmmm. There's that adjustment thing again.

Any time interested parties, whether it's the government or Wall Street, start arguing for adjusting the numbers, I start to worry.