The Search for Yield - A Warning to Investors

A brief section entitled "Has the Search for Yield Gone Too Far" in the IMF's most recent Global Financial Stability Report provides investors with a summary of all that is wrong in the global bond market today. and why investors must be wary.

As all investors know, the current extended period of ultra-low interest rates has pushed investors to "seek yield".  This means that in order to get a decent return on an investment, investors have had to take on additional levels of risk, risk that they may not ordinarily have been willing to take.  For example, investors that normally invested in the "safest assets" (at least in the eyes of the market) like ten-year Treasuries, have seen the yield do this since the Great Recession began:

In order to get a return that meets traditional expectations, fixed income investors may have invested in higher risk corporate junk bonds which have a higher yield as shown here:

The IMF notes that the global universe of fixed income products looks far different than it did before the Great Recession.  While the investment grade fixed income market has mushroomed from $19.5 trillion in 2007 to $45.7 trillion in 2017, the portion of bonds that yield over 4 percent has dropped from 80 percent in 2007 to less than 5 percent as shown here:

In fact, of the $45.7 trillion in investment grade fixed income investments, only $1.8 trillion have a yield of over 4 percent, down from $15.8 trillion in 2007.

This has created a dynamic shift in the bond market.  Foreign investors have shifted away from their traditional investments in U.S. Treasuries into higher-yielding U.S. corporate bonds with non-U.S. investors now holding nearly 30 percent of U.S. corporate debt, up from 12 percent and1990 and up 25 percent from before the Great Recession.

Not only has the search for yield impacted the U.S. corporate bond market, it has had a profound impact on the issuance of debt by the world's emerging market economies.  The current prolonged period of ultra-low interest rates has led to increased borrowing by many of the world's lower-rated nation as shown here:

...and here:

What is not terribly surprising is, that with the desperate search for yield, non-resident investors are buying increasing volumes of higher-risk emerging market debt since the Great Recession as shown here in billions of U.S. dollars:

...and here shown as a percentage of GDP:

In the first eight months of 2017, non-resident investors picked up $205 billion of emerging market debt, the highest level since 2015 and 2016 and 2017 looks set to approach the levels last seen during the period from 2010 to 2014.

The great concern about the move by investors into lower-rated debt issued by nations with questionable economic futures is that the level of interest owing on the increased level of outstanding debt has risen substantially when measured against revenues as shown here:

It is also concerning that the demand for lower-rated debt has pushed the spread in bond yields  (i.e. the risk premium) between emerging market nations and higher-rated U.S. debt as shown here:

The global bond market is no longer reflecting the level of risk that investors face when buying debt from emerging market nations, nations that will likely face debt crises similar to the PIIGS crisis back in the first half of the current decade.  In fact, if you want a sense for how the debt market has lost its way and no longer reflects reality, look no further than the yields on the following PIIGS debt (2 year bonds):

Italy:

Greece:

It is hard to imagine that either nations' fiscal picture has improved to the point where the yield on their 2 year debt should be either negative (Italy) or just below 1.75 percent (Greece).

Let's close this posting with a quote from the IMF on the current search for yield:

"The low-interest-rate environment has stimulated a search for yield in markets, pushing investors beyond their traditional risk mandates. This has compressed spreads, reduced the compensation for credit and market risk in bond markets, contributed to low volatility, and facilitated the use of financial leverage. While these supportive financial conditions have helped boost growth, as intended, they have also raised the sensitivity of the financial system to market risks. Prolonged normalization of monetary policy could extend these trends. Unless well managed, these rising medium-term vulnerabilities could lead to significant market disruptions if risk premiums and volatility decompress rapidly." (my bold)

In other words, investors beware.  You have been lulled into a false sense of bond market security.  This time is not different; high risk debt is still high risk debt no matter what yield may suggest and the odds of a cascade of defaults is certain to rise over time, leaving investors with a very uncomfortable haircut.

The Global Debt Trap

Updated September 2017

In the 2017 edition of the Bank for International Settlements annual report, BIS outlines where the economy's Achilles heel lies - the accumulation of unprecedented levels of debt, a situation that could prove to be critical for several highly indebted nations as you will see in this posting.  While the bank for central bankers notes that the global economy has strengthened over the past year with economic growth rates approaching long-term averages, there are four risks that could threaten the sustainability of the expansion:

1.) a rise in inflation

2.) financial stress as financial cycles mature

3.) weakening consumption, demand and investment because of growing debt levels, particularly at the household and corporate levels

4.) a rise in protectionism

In this posting, I want to focus on point three; the risks to the global economy associated with what BIS terms "unusually high debt levels" and "unusually limited room for policy manoeuvre(s)", that being the room for central banks to raise interest rates.

Here is a graphic showing how global debt as a percentage of GDP has risen since the end of 2007 (i.e. the beginning of the Great Recession) for advanced economies (AE) and emerging economies (EME) broken into general government debt in yellow, non-financial corporate debt in blue and household debt in red:

Here is a graph showing how public and private non-financial corporate debt has soared as interest rates have plummeted since 1986:

One of the great dangers is the sharp increase in corporate debt among emerging economies, particularly where that debt is accrued in foreign currencies, a situation that leaves companies highly vulnerable to unfavourable changes in exchange rates. 

Here is a tell-all quote from the report:

"As markets have grown used to central banks' helping crutch, debt levels have continued to rise globally and the valuation of a broad range of assets looks rich and predicated on the continuation of very low interest rates and bond yields".  

One look no further than the highly overvalued real estate of two major centres in Canada, Vancouver and Toronto, where a crack shack will set you back over a million dollars, to see how central bank policies have completely distorted at least one aspect of the consumer marketplace.

Next, let's look at a graphic that shows us two measures which can be used as early warning indicators of future financial overheating and banking sector distress as follows:

1.) Credit-to-GDP gap - the deviation of the private non-financial sector credit-to-GDP ratio from its long term trend (i.e. how quickly debt has raced ahead of the long-term trend in economic growth).  A reading above 10 is considered dangerous and readings between 2 and 10 are considered risky.

2.) Debt service ratios (DSR) which are measured as the sector's principal and interest payments in relation to income.  Debt service ratios greater than 6 are considered dangerous and those between 4 and 6 are considered risky.

Now, let's look at which nations are in the debt trap danger zone, the key part of this posting.  Here is the graphic with danger zones highlighted in red, the risky zones highlighted in beige and includes a column which shows which economies will be in danger if interest rates rise by 250 basis points:

As you can see, the credit-to-GDP gap has reached levels signifying higher banking sector risks in Canada, Hong Kong, China and Thailand.  As well, if interest rates rise by 250 basis points, the rise in the debt service ratio suggest that the domestic banking system in Canada, China and Hong Kong are under threat. 

Let's look at the several examples showing what household debt servicing burdens looks like under different interest rate scenarios (in percentage points) for Canada, the United States, the United Kingdom, Spain, Australia and Norway:

It is interesting to see that Canadian and United Kingdom households are highly vulnerable to increases in debt servicing ratios when interest rates rise, yet not as bad as their peers in Australia and Norway, two nations  famous for their highly overheated housing market and growing household indebtedness.  Fortunately for households in both the United States and Spain, significant debt deleveraging after the Great Recession makes them somewhat more immune to interest rate increases.

So, what does the central bank for central banks think could happen when central banks begin to raise rates given the current debt inventory?  Here's a quote:

"Policy normalisation presents unprecedented challenges, given the current high debt levels and unusual uncertainty. A strategy of gradualism and transparency has clear benefits but is no panacea, as it may also encourage further risk-taking and slow down the build-up of policymakers’ room for manoeuvre." (my bold)

In other words, central banks are damned if they raise interest rates and damned if they don't, largely because their policies have resulted in both risk-taking (i.e. the creation of asset bubbles in stocks, bonds and real estate) and excess levels of debt.  Gradually raising interest rates could well prove to be no solution to the problem of asset bubbles and debt accumulation since a rate increase of 25 basis points here and there is relatively meaningless, particularly when compared to the interest rate increases of past economic cycles.

Here's a summary from the report which succinctly explains the potential debt crisis and how the world's central banks have painted themselves into a "monetary policy corner":

"Otherwise, over long horizons, failing to constrain financial booms but easing aggressively and persistently during busts could lead to successive episodes of serious financial stress, a progressive loss of policy ammunition and a debt trap. Along this path, for instance, interest rates would decline and debt continue to increase, eventually making it hard to raise interest rates without damaging the economy. From this perspective, there are some uncomfortable signs: monetary policy has been hitting its limits; fiscal positions in a number of economies look unsustainable, especially if one considers the burden of ageing populations; and global debt-to- GDP ratios have kept rising." (my bold)

The Federal Reserve and the world's other most influential central banks have borrowed from the future.  The long period of near-zero interest rates will prove, in the long run, to be extremely dangerous to the global economy, and could end up causing more economic pain than the Great Recession, largely because of the central bank fuelled "debt trap" that has been created since 2008.