Friday, December 22, 2017

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):

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.

1 comment:

  1. The former chief economist of the Bank for International Settlements recently issued a warning that global financial markets were not on sound footing. He told Bloomberg "the system is dangerously unanchored."

    During that interview, White pointed out that Europe's creditors are likely to face some of the biggest haircuts. The following article argues that central banks have only postponed the inevitable by continuing to print money and expanding the monetary base.