The insatiable appetite for yield has prompted investors to take on ever more exposure to the highest yielding areas of the bond market.
The search for yield appears unstoppable.
Global investors’ voracious appetite for income has been a near-constant theme since the end of the financial crisis, propelling bond yields to record lows. Riskier segments of the fixed income market, such as corporate and emerging market debt, have posted stellar returns. And although these assets have endured some wobbles in recent years – the eurozone crisis and the 2015 energy collapse among them – they have always bounced back, seemingly stronger than before.
Does this behaviour signal complacency, or does it signify a secular trend that is simply too overpowering to stop? As we celebrate the eighth year of a post-global financial crisis credit rally, markets are faced with an ageing economic cycle and impending signs of shifts in monetary policy.
It is only appropriate to ask if these warning signs will be sufficient to finally damage those higher yielding areas of the bond market that have been largely impervious in recent years to slow growth, escalating leverage and growing political risks. from the short-term outlook. For those worrying about the long-term sustainability of the search for yield, stop worrying. This trend has staying power. The shorter-term view is more cyclical and warrants more caution. Warning signs are mounting from a variety of credit quality measures, and valuations are challenging. Even with a shorter-term focus, however, we lack clear evidence that near-term risks will overpower the secular wave in 2017.
A quest for higher yield in fixed income markets is typically expressed through one of the following strategies:
- Higher exposure to spread/credit risks: an overweight to corporate credit, emerging market debt, and mortgage credit can be an efficient way to boost portfolio yield.
- Duration extension: yield curves are upwardly sloping, offering investors higher yields for buying longer-duration assets.
- Exposure to less-liquid instruments: illiquid assets can provide healthy yield advantages over similar quality, highly liquid assets.
Greater income requires greater risk, and all of the above investor behaviours have become more prevalent in recent years. Indeed, we have written in prior ‘Perspectives’ of the dangers of extending duration to pick up extra income. The term premium, a measure of the incremental compensation one earns for extending maturity, remains woefully mispriced. We believe rates will rise, driven largely by normalisation in term premia, making duration extension an unattractive yield enhancement strategy. We therefore focus here on the most common strategy for enhancing income – assuming more risk through spread products.
The search for yield to remain robust over the long term
The macro environment will change. Fiscal and monetary policies will change. Geo-political risks will shift. But the appetite for yield will likely persist, and here’s why:
- Interest rates are low and likely to remain so. We do believe yields should rise, but the speed limit on global growth is constrained by low productivity and tepid labour force growth. Rate rises should be contained, but the key point is that a 3% yield on 10-year US Treasuries, if achieved, would still leave yields very, very low. Low rates entice investors to seek better yields with their assets.
- The behavioural segmentation of income and capital gains shows no signs of receding. Savers have historically behaved as though income was something to spend, and yet capital gains were something to be saved. This may have been a feasible strategy when interest rates were 5% or higher, but portfolios simply cannot generate sufficient income at ultra-low rates. Logically, investors should focus on total return and, given the lower tax rates for capital gains, should even have a preference for capital gains over income. Their investing behaviour indicates something different. Yield is paramount to many savers, and they are myopically drawn to income like moths to a flame.
- Higher-risk fixed income is now mainstream. Investors often split fixed income into safe and risky buckets. Many investors traditionally leaned toward ‘safe fixed income’ exposure in their portfolios to complement ‘risky equities’. But better understanding of risk and return has broadened the definition of safety to include many yield-oriented investments. High yield and emerging market bonds have characteristics that make them compelling assets in both fixed income and multi-asset portfolios.
- There is acceptance that few investors need heavy exposure to the quality, or the liquidity, of government bonds. Liquidity comes at a cost – lower yield – and investors have become cognizant of needlessly paying to mitigate a risk they should be assuming more of.
- Ageing demographics are shifting many savers’ risk tolerances lower. Portfolios are allocating away from equities and towards safer assets. The next rung down on this ladder encompasses the higher-yielding segments of fixed income.
The search for yield is not new. It has been a dominant feature of each of the last three credit cycles. The return distribution of corporate and emerging market bond risk is tailor-made for luring investors to stretch for yield. Investors are rewarded for embracing spread risk roughly 70% of the time. Outcomes in the other 30% of cases are often brutal, reflected in sharp price corrections. But, absent a full-blown crisis, these bear moves quickly reset expectations that the odds are skewed in the investor’s favour. The yield hunters eagerly return.
The graphs below illustrate how the diversifying benefits of high yield and emerging market bonds complement their income orientation to make them an attractive allocation in fixed income portfolios.
Today’s environment has fostered a number of myths relating to the search for yield. Let’s put a few of those to bed:
- Today’s search for yield is unparalleled – The hunt for yield today doesn’t begin to approach what was witnessed in the lead up to the 2008 crisis – although the excesses in that period were more pronounced in the financial sector and were relatively absent among savers.
- The reckless scramble for yield has pushed valuations to bubble-like extremes – Long-term valuations (as judged by yield spreads) are certainly not cheap, but they are no in bubble territory. Some areas of MBS and emerging market risk are not far from median valuations, and credit spreads remain meaningfully above 2007 levels.
- The riskiest areas of the bond market are teeming with ill-informed mutual fund investors, ready to rush for the exit at the first sign of trouble – Yes, markets will endure corrections, but there is no basis for the argument that a broad base of fixed income assets of all types won’t continue to be the backbone of a fixed income portfolio.
- Central bankers, through quantitative easing and large-scale bond buying, have prodded investors into an imprudent and unsustainable grab for yield – Easy monetary policy has contributed to lower refinancing risk, lower default risk, better credit quality and tighter spreads. Direct bond purchases have also helped. But this is always the effect of easy monetary policy, and there is nothing to suggest that this cycle has incited behaviour any more reckless than previous easy-money episodes. The portfolio substitution channel of QE, whereby investors buy credit risk at the expense of sovereign risk, appears to have had a relatively weak effect on spreads.
Investors chased yield before the 2002 balance sheet recession, and they chased yield in the period leading up to the 2008 crisis. If they behaved in this way when yields were two to three times higher, there is little reason to think investors will abandon this strategy on anything other than a short-term basis.
A structural shift in the use of capital-weighted benchmarks is also impacting the way in which investors approach fixed income. Standard, cap-weighted benchmarks have long dominated the industry and many of these include a high proportion of government bonds. But these weightings are not based on the needs of an investor; they merely reflect the entities that have piled up the most outstanding debt. Investors have formulated better ways to tie products to their needs, either through benchmark-agnostic approaches or the adoption of more credit-intensive products. Over the long term, a yield tilt has provided better risk-adjusted results for investors.
The short-to-intermediate-term view: danger is lurking
Investors will not take comfort from a purely longterm view. Indeed, markets can fall precipitously over short-to-medium- time horizons. The mere existence of a strong appetite for income does not imply that income-oriented assets will be reasonably valued. Rather, it is a reminder that valuations are likely to occasionally diverge materially from fair value. The secular trend will remain an important tailwind, however, and will serve to reverse most corrections. But for those with a short- to- medium horizon, we now look at the current state of play.
Make no mistake about it – the asset classes that provide high levels of income are relatively expensive. Moreover, there are warning signs that the fundamental drivers underpinning these markets are worsening. It is important not to grow too short term when speaking of the credit markets. We are not concerned with forecasting a mere correction. Nor do we believe there are timing tools available that are robust enough to do that consistently. Any yield-seeking environment will be populated by numerous corrections, some of them material. We are concerned with issues that might impact the broad trends, end the credit cycle or represent a regime shift that would reverse the powerful ‘search for yield’ secular trends.
There are several factors that emerge as important lead indicators for a major turning point in credit cycles and asset class performance:
- Deteriorating measures of corporate and sovereign health
- A less accommodative policy backdrop
- A reversal in the macro backdrop/an increase in macro volatility
- Depressed market volatility
- Extreme valuations.
The picture today is a mixed one, but is more worrisome than it has been since the beginning of the recovery in 2009.
Corporate health, as measured by leverage and interest coverage, has been worsening. The stock of debt relative to earnings, cash flow and equity all reside in the worst 20% of historical observations. The policy backdrop remains supportive, but is growing less so. The Fed is tightening and other central banks will at best remain static. But real rates remain extraordinarily low. High quality companies can routinely borrow at rates lower than their nominal growth rates.
Last year’s deflation scare is over, and growth is rebounding, albeit modestly, across most regions of the globe.
Market-based metrics, in isolation, are poor indicators of a turn in the cycle. Poor valuations are valid indicators of prospective return and risk, but they are poor timing indicators. But here, the news is not good. Volatility, as measured by any number of measures across risk assets is at very low levels. From a contrarian standpoint, this highlights the market’s belief that little is on the horizon to disrupt current trends. Valuations, although not at bubble levels, remain very expensive. For investors looking for a repeat of recent strong performance, starting valuations make that a near-impossible task.
Macro volatility is the key
Many of our credit indicators are flashing amber, and some of them red. This is a time to be vigilant.
Our work on credit cycles has highlighted that the factors that create the end of one credit cycle are often not the catalysts for ending the next one.
Are there unique features of the current cycle that might give us clues as to what might disrupt the status-quo? We believe there are. The one shift that would seriously undermine the search for yield trade is macroeconomic volatility.
Low macro volatility is more important than a strong or improving macro backdrop. Most of the high yielding area of the fixed income markets do not require strong growth to prosper. Slow and steady growth is most often the perfect recipe.
Rapid growth, particularly when accompanied by higher inflation, is worrisome because of the policy response it induces. Receding growth is also a worry, particularly when growth or inflation is near recessionary levels.
The grab for income is global and international flows are helping to further suppress volatility. The US, for example, has the most aggressive central bank, but it also has among the highest developed market yields. Capital tends to flow where yields are highest, and the US is a clear beneficiary.
Figure 4 shows the percentage of yield in global markets comprised by the US dollar market. It is little wonder that foreign flows have been flooding into the US income trade.
Low volatility is the ingredient that perpetuates and reinforces the search for yield. A sustainable lowyielding, low-growth environment simultaneously alleviates concerns of economic overheating and economic recession. One of the defining characteristics of the post-crisis growth trajectory has been its stability. Many may recall the proclamations in 2005 – 2006 that the business cycle had been killed and recessions banished to the annals of history. But economic volatility is even lower in the current cycle. There is a tried and tested belief that policy makers will jump to the rescue if this glide path is threatened to the downside. The result has been a global economy constrained on the upside by the many global deflationary forces and yet protected on the downside by policymakers. It does not get much better for driving a drawn-out search for yield.
It is difficult to see credit or emerging markets underperform for long if the global economy can remain on this tightrope. For without a collapse in the economy, there will not be a broad-based collapse in cash flow, suppressing default risk.
The world has also been able to judge the possible outcomes to a high debt scenario. Japan has shown that a sluggish growth environment does not always portend doom. In fact, it may be more likely to produce persistently low yields.
Many of the world’s economies do not possess the excess savings of Japan, and thus a direct analogy may be inappropriate. But many have a better ability to suppress real rates, and some, like China, control both the banking system and many of the most levered creditors. Policy makers still have options to remain in this low growth, low inflation channel.
Threats to the search for yield in the next two years will stem from threats to this moderate pace of global growth. In particular, the following areas should be watched for trouble:
- A monetary policy mistake: central bankers kill recoveries, not the passage of time. Overly aggressive tightening from the Federal Reserve is the biggest risk in this area. Watch for signs, either through the shape of the yield curve or the demand for credit, that the Fed is overdoing it. Likewise, a less accommodative stance from the eurozone or Japan might surprise markets and risk crimping the international search for yield.
- Materially higher real rates: defaults should stay low so long as real rates stay low.
- China: a well-managed Chinese slowdown will reinforce the search for yield rather than endanger it. A badly managed slowdown will create debt-deflation fears.
Markets may be volatile even if the macro backdrop remains more muted. The Trump administration’s political agenda, Fed tightening, Brexit, and the shape of the nascent eurozone recovery are among the many factors that will drive credit and emerging market spreads in the coming year. By themselves, however, they have very little chance of altering the key underlying trends. Investors should filter through the noise and maintain their focus on factors that might permanently alter the low-growth, low- inflation dynamic. Without a change in those underlying fundamentals, corrections are likely to be just that corrections.
There are dangers of such a regime change on the horizon, but none of these dangers would fall into our central case projections. A regime shift is a risk and not a forecast. Nonetheless, the relatively expensive valuations of many asset classes leave no room for complacency. A modest economic slowdown or disappointment in the Trump agenda is not fatal, and may be a positive if some type of stimulus emerges in 2018 when the economy needs it. A full-employment picture in the US should not damage these prospects. On average, recoveries last another four years from the point at which full employment is reached. A soft-landing in China should actually extend the global search for yield.
Those heavily exposed to spread risks and worried about a cyclical correction should seek the proper balance in their portfolios. Increasing allocations to higher quality, intermediate duration bonds is one path. Seeking strategies designed to employ aggressive asset allocation between high- and low-risk assets is another.
Investors will need to discern between a market correction, the end of a credit cycle, and the end of the global search for yield phenomenon.
Absent a fundamental threat to the current low growth, low-inflation environments, the trend remains your friend. The demand for yield is a defining characteristic of this decade’s investment environment and shows no signs of vanishing.
So what should investors do?
Firstly, the compensation for assuming credit risk is historically low. Investors should consider whether the additional yields on such bonds adequately offset the higher risks. Second, the incremental yield for extending maturity is also historically low. Investors will perhaps find a better risk-reward trade-off in short to intermediate bonds. Diversification is always a prudent strategy, but especially in the current, low yield environment. It is worth remembering that corporate bonds are not the only game in town. The addition of emerging market, mortgage and government bonds can help improve returns across a range of scenarios. Finally, the search for yield may persist so investors should take steps to protect their portfolio, but should always consider staying invested – after all, cash is a poor investment over time.
Jim Cielinski – Global Head of Fixed Income – Columbia Threadneedle Investments