Will investors get burnt by "reaching for yield"?
In these extraordinary times for markets it can be difficult for even the savviest of investors to have confidence in their investment decisions. Although the appeal of a fixed stream of income can be appealing in these circumstances, there are reasons to be wary.
Across much of the developed world central banks are undertaking large-scale asset purchase schemes in attempts to stabilise, and in some cases to boost, crisis hit economies. While fears that these measures would lead to Weimar-style hyperinflation have proven wide of the mark a combination of central bank purchases and the demand for safe assets due to increased uncertainty is putting significant stress on bond markets.
You do not have to look far to see this in action. The yield on the benchmark 10-year US Treasuries is currently 1.7% with inflation running at 1.5%. In the UK the situation is even worse for investors looking for income with 10-year Gilts yielding 1.74% but CPI inflation at 2.8% – e.g. a negative real yield.
Even in the troubled Eurozone there spreads are coming down with France’s 10-year yield falling to 1.7% on April 23, its lowest level point since 1990.
So far the high price for safety has not dissuaded people from continuing to mop up these assets as soon as they hit the market. What this means, however, is that those looking for income above inflation are being pushed further and further up the risk spectrum.
Patrick Armstrong, Pieria expert and Chief Investment Officer at Armstrong Investment Managers: “Yield is definitely driving investment at the moment, even junk bonds and emerging markets have seen spreads contract sharply. If you get an unexpected jump in interest rates it could have big repercussions with projects that assumed current funding costs would last failing.”
As Armstrong alludes to this “reach for yield” also poses systemic risks due to misallocation of investors’ capital. Ploughing money indiscriminately into high-yielding fixed income instruments could mean that the economic consequences in the event of a rate rise could be all the more severe.
A recent paper from the Harvard Business School entitled “Reaching for Yield in the Bond Market” looked into this phenomenon in some depth. The authors state:
“A key principle of finance is that in equilibrium there is a positive relation between the risk of an asset and its expected return. Comparisons of returns, therefore, are only meaningful on a risk-adjusted basis. But risk cannot be measured perfectly. This creates an important limitation in the delegation of investment decisions.
“Financial intermediaries and investment managers that are evaluated based on imperfect risk metrics face an incentive to buy assets that comply with a set benchmark but are risky on other dimensions; in other words, they have an incentive to “reach for yield”. This could lead to excess risk taking in financial institutions, a persistent distortion of investments and, potentially, amplification of the overall risk in the economy. Indeed, reaching-for-yield is believed to be one of the core factors contributing to the buildup of credit that preceded the recent financial crisis.”
This squeeze on yields has led to a number of commentators warning of a bond bubble. It is undeniable that the performance of almost all bond classes since the onset of the Great Recession has been impressive and has now weighted risks towards the downside. Nevertheless, there as yet there have been few signs of a sudden implosion in bond capital values.
One of the main problems, as Armstrong suggests, is that in the meantime the misallocation of capital towards companies with precarious finances could increase the vulnerability of economies to sudden shocks. If so, this suggests regulators should be paying close attention to developments within bond markets.
Of course, another possible consequence of this yield squeeze could be to push people into dividend-yielding equities. This strategy could be all the more interesting if rumours of a shift in central bank asset purchases are accurate.
Increased liquidity in markets from central bank purchases already appears to be having an impact. The chart below shows the recent trajectory of 5-year Treasury yields against the performance of the S&P 500:
Bloomberg reports that in a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland, 23% of respondents indicated that they own shares or plan to buy them. Already the Bank of Japan, the Bank of Israel, the Czech National Bank and the Swiss National Bank have all moved to increase their equity holdings.
If this trend continues it could have very interesting implications. Bond purchases, by their nature, have a fixed capital upside limiting the return that investors could get by riding on the coat tails of central banks. These constraints, however, do not apply to equity prices.Are we likely to see a wholesale switch? Possibly not, but central banks dipping their toes a little deeper into equity markets already has some high profile supporters. What can be said with some confidence is that the price for not taking risks in the current market continues to grow.