Over the last decade, investors have been incentivized to “hunt for yield” in riskier asset classes by unorthodox monetary policy, which sucked the yield out of traditional “safe havens.”
Investors should remember that “safe haven” asset classes may not have higher yields, but can potentially provide protection in the later stages of the economic expansion.
When selecting fixed income investments in this environment, investors should think carefully about knowing what they own, evaluating performance and determining whether cheaper is better.
The decade-long hunt for yield
As the global economy struggled in the wake of the financial crisis, global central banks stepped into the breach, launching multiple waves of asset purchases and implementing low or even negative interest rates to stimulate growth. Questions remain over the effectiveness of this policy, but it certainly did kick-start the hunt for yield. Investors moved out of “safe haven” assets, which now lacked yield, and ventured into other areas of the financial markets seeking stronger returns.
The strategy of taking on more risk in order to sustain traditional fixed income yield is not necessarily wrong. In fact, over the course of this cycle, it has delivered results to investors. A portfolio invested just in U.S. Treasuries returned 2.1% per year between 2009 and 2018; meanwhile, sectors like local currency emerging market debt (EMD) returned 8.2% per year, and U.S. high yield returned 11.1% per year*. In short, investing in higher yielding sectors delivered higher returns over the last decade.
However, in the later stages of an economic expansion, reaching for yield becomes more concerning. Exhibit 1 compares the yield of different fixed income sectors to their correlations to equity market performance; a proxy for risk. Essentially, it illustrates a very simple concept – higher yield equals higher risk. As a result, investors should be wary of allocating too much to higher risk fixed income: these sectors may offer the juiciest yields, but they tend not to provide portfolio protection in the event of a market sell-off.
U.S. investment grade: The growth of BBB corporate debt, the lowest investment-grade (IG) rating, has been alarming. In December 2008, 29% of U.S. corporate debt was BBB. As of January 2019, that number was at 49%.
U.S high yield and leveraged loans: In 2018, 87% of debt issuance was considered to be covenant-lite, meaning that it offers very little or no protection to bondholders. This is a record high in the asset class.
European high yield: 21% of European high yield trades had a yield below that of the U.S. 10-year Treasury, despite having an average credit rating 12 notches below it.
Emerging market debt: In June 2017, Argentina issued a 100-year bond at a yield of 7.9%. Despite the fact that Argentina has defaulted six times since 1950, this debt issuance was 3.5x oversubscribed. Furthermore, the amount of debt issued by emerging market (EM) corporates has increased dramatically since 2008. Total market cap has risen from $200 billion to over $1.2 trillion, making it a similar size to the U.S. high yield market.
These examples are not meant to generate fear amongst investors, nor to suggest that we should not venture into these asset classes. Instead, they highlight the need to be active and diversified in managing fixed income risk allocations, and demonstrate how some areas of the financial market may be too exuberant. Therefore, investors should proceed, but with caution.
EXHIBIT 1: CORRELATION OF FIXED INCOME SECTORS VS. S&P 500 AND YIELDS
You may want to consider
Don’t Let Rates Push You Around
See how we can help you craft a stronger Fixed Income portfolio.