The perils of being a yield chaser

A series of market pressures – from quantitative easing to increased regulation – are making the search for yield increasingly tough and putting investors under pressure to take greater risks

In recent years, quantitative easing (QE) and regulatory changes have driven down interest rates, flattened the yield curve and pushed investors into higher risk assets in order to pick up yield. 

What started as emergency policy to save the financial system has turned into a longer term policy that’s had an impact on savers and pensions. Is this likely to change soon? 

Not according to David McFadzean, Head of Investments at Nedbank Private Wealth. He thinks a change of tack is difficult and warns that the dangers in the present climate are “palpable”.

“The level – and expected level – of interest rates has a huge influence on global capital flows, infrastructure spending, investment plans and currency markets,” he says. 

“In many developed markets, including the UK, interest rate decisions are now taken independently, at one remove from government. This means that some of the unintended consequences of QE can be difficult for governments to address.”

McFadzean points out that one of the key concerns around long-term QE is that increasing the supply of money can cause inflation. Even worse, if the increased money supply does not make it through to the real economy – for major projects and infrastructure, for example – then there’s a risk of inflation without economic growth, so-called stagflation.  

There is a further risk, too – domestic currency can devalue, making imports more expensive. The end result is a triple-whammy on savers: lower interest rates, capital erosion through inflation and lower purchasing power due to a devalued currency.

Difficult choices 

Nigel Garrard, Head of Asset Management at Butterfield Bank (Guernsey), agrees that meaningful movement on interest rates is unlikely to change in the foreseeable future.

“What started out as an emergency measure is now the norm,” he says. “I really don’t see the interest rate environment changing much from where we are now.” 

Garrard accepts that investors have been forced up the risk curve in chasing yield, but warns that there could be dire consequences if they lose perspective and become too cavalier in their exposure.  

“At the outset of a client relationship, you have to ensure that the investment mandate balances requirement for risk with the capacity for loss. In many instances, you have to have some pretty grown-up conversations – maybe suggest drawdown on capital or a change in spending habits.”    

Of course, different types of investors have different yield requirements, and tax implications vary too. While some may have the comfort of a well-funded retirement from various income sources, many who expected their pension and savings provision to be more than adequate are facing a rude awakening.  

Pension pot blues

While the monetary policy of the central banks may have helped recovery from the 2008 financial crash, it has offered little comfort to pension investors. The reason is that pension funds have regular payments to make – they need income from their investments to pay today’s and tomorrow’s pensioners.

But many pension funds face funding gaps, where the present value of future liabilities exceeds the market value of their assets.

They can then be forced to invest in riskier assets to try to plug this gap. Many corporate trustee investors need to balance the obligations they have to beneficiaries who are entitled to capital growth with those entitled to income. 

As McFadzean explains, if they are chasing higher income for the latter group, they may be taking more risk than is suitable for the former group. “And of course, for many investors, income is taxed at a different rate from capital growth – which can distort investment decisions and thus capital allocation,” he says.

Upping the risk 

When we talk about pension funds or individual investors migrating to riskier assets, what does that mean in practice? Essentially, the move up the risk scale (since 2008) has been from cash to government bonds, to corporate bonds and then emerging market and high-yield bonds. 

As the rate of return from the lower risk options becomes less attractive, the appetite for spicier alternatives grows stronger.   

Mark O’Connor, Head of Investment Management at Brooks Macdonald, believes the fundamentals, for the foreseeable future at least, point to little gain unless you ratchet up the risk factor. “While markets, especially the US, are back to their January 2018 highs (in forward PE ratio terms), the backdrop regarding central bank policy accommodation is very different,” he says.

“Then, the markets were dealing with a US Federal Reserve focused on balance sheet reduction, as well as an expectation of rising interest rates. Now, we have balance sheet expansion at the Fed (and a restart of European Central bank QE), as well as three interest rate cuts from the Fed in 2019. This provides for a more supportive backdrop to risk appetite.”

Mike Hollings, a Partner at Shard Capital, argues that investors seeking income will have to get used to sub-par returns as bond market returns flatline – showing little sign of upward momentum.  

In some instances, rules are in force that bind investors to hold negative yielding assets. For instance, a fund manager may have a mandate from their institutional investor (often a pension fund) requiring them to include, for example, a certain percentage of (negative yielding) short-dated Japanese or German government bonds in their portfolio.  

Where flexibility allows, pension fund managers are inevitably under pressure to try and increase their options on where they can invest – to take on more risk for the chance of improved performance. 

As Hollings explains, where yields on gilts and investment grade bonds are just not cutting it, the temptation is to try and push for higher octane, but potentially perilous, alternatives.

“For instance,” he says, “if you have a pension with Siemens in Germany and you are not even close to hitting the target return, there are a lot of disgruntled scheme members. Pension fund managers are restricted on where they can invest, so they may lobby politicians to change the rules to allow them to invest in things like private equity.” 

Liquidity problems 

If compression in government bond yields and wafer-thin spreads currently available on investment grade bonds weren’t enough to worry about, a lack of liquidity in the bond market is another major headache. 

Before 2008, dealers – essentially banks – acted as the brokers between buyers and sellers, taking bonds into their inventory for a short period of time and then selling them at a later date. 

By running big inventories, the banks were often prepared to buy bonds even if there was no immediate opportunity to sell them. This helped ease market pressure and improved liquidity conditions during periods of stress.

Since then, changes in regulation regarding capital requirements, such as Basel II, have resulted in general bank risk aversion and major shrinkage in dealer inventories.  

Hollings believes the situation is alarming. “Nobody really appreciates just how illiquid these markets are now. What some would call the knee-jerk regulatory response to the great financial crash in 2008 has resulted in possibly the worst liquidity conditions in bond markets over the last 35 years.

“While we don’t believe interest rates in major economies will rise any time soon, we are very aware of the elevated duration risk in most bond markets currently.”

Warning signs

So, does an indiscriminate chase for yield, excessively poor liquidity, and political risk threatening emerging market bonds, mean we could be close to a market crash? 

Undoubtedly 2019 provided no shortage of headwinds in the emerging economies; trade hostilities between the US and China; geopolitical flashpoints in the Middle East; and increased social unrest in Hong Kong, Latin America, Lebanon and Iraq.   

Given these negative factors, the relatively strong performance of the emerging markets debt (EMD) asset class seems surprising. 

But can such resilience continue? What does 2020 hold in store and should investors be treading carefully? Garrard certainly thinks so. While he doesn’t foresee a major collapse as imminent, he is concerned that several factors could tilt the balance. 

“We have seen some positive moves on US and China trade deals that would be good for the global economy, so less concerns in general for riskier assets. But with the Trump administration, things can change quickly. 

“You also have variables like the coronavirus – we don’t really know how that is going to play out and how it will affect global supply chains. And what if another virus hits soon after?” 

The worst-case scenario would be bond investors, in a stressed market, trying to sell when there is no natural buyer the other side. High yield is typically less liquid than investment grade, so when liquidity evaporates, the effects are more pronounced in the high-yield market.  

Hollings’ conclusion is that bond investors are being asked to take more and more risk for less return, which might call for a rethink. 

“If you’re chasing yield, you have to be sensible in your portfolio positioning. For instance, utility stocks could offer significantly better inflation-adjusted yields than bonds,” he says. “And with the selective use of options, investors could mitigate downside risks.” 

A little insurance never does any harm.