Has the quest for yield gone too far?

Confronted with negative real yields on AAA government bonds, investors have gone on an enthusiastic ‘quest for yield’. Investment grade corporate bonds are often the first port of call, then high yield and emerging debt bonds are added to portfolios. From a fund manager’s point of view, these market segments have become crucial sales opportunities in an otherwise depressed asset management market – with aggressive marketing efforts as a consequence.

The inflows into these categories have been huge – but worrying questions arise. Investment grade corporate bonds now yield very little over government bonds. It is safe to say that without a sharp eye on fund fees and underlying transaction costs, the yield pickup an investor obtains is rather less than the management fee he pays to many investment grade funds.

SIGNIFICANT SPREADS

Moving further out into the risk spectrum, high yield markets still offer significant spreads. Still, the race down towards the 500 basis point minimum spread that one should reasonably demand for default risk and illiquidity is reason for caution. Besides, the performance of both passive exchange traded funds (ETFs) and active managers significantly lagged the index over the last five years.

There are some very valid reasons for that – according to one calculation, just replicating the high yield index will present trading costs of 60 basis points per annum. Cautious (or prudent) managers confronted with today’s reasonably frothy markets will underperform even more by missing out on the bounce-back of high risk issues.

But more problematic is that quite a few of the ‘star’ managers performed well during the credit crisis for the wrong reasons, such as the fact that illiquid positions were hard to price in the eye of the storm and remained in the portfolio at stale prices.

There will be new threats challenging active managers: regulation such as Dodd-Frank and Basel III will cause higher trading costs, especially in the least liquid segments. Record inflows from retail investors will at some point be reversed. Passive management will not be the answer. Rather, careful up-front research and realistic estimates of net returns are important in determining the role of high yield in today’s portfolios.

Emerging market debt is the third port of call for yield seekers. Tremendous inflows have hit this market segment, starting with hard-currency issues but now, more and more, also in local currency issues. Where large inflows hit limited issuance (emerging markets governments generally do not have the budget deficits of the West), remarkable prices result. Ranked among emerging markets countries, the yields of Spain and Italy would look quite attractive. In September, Zambia issued a 10 year dollar bond at a yield of 5.625 per cent. This yield may make perfect sense for emerging market debt managers themselves, but many of their clients would consider that a surprisingly low rate.

The point may be that it is generally not wise to wait for the specialist manager to raise a warning on the valuation of his market segment.

Last but not least in our concerns when seeking ‘quest for yield’ opportunities for our clients is the risk profile of many of the very best managers. There has been a very strong ‘winner takes all’ effect in recent fixed income fund flows. Only a few fixed income managers have demonstrated positive alpha through the turmoil of the last six years, and these few stars have grown their assets under management in an exponential manner.

RAISING CONCERNS

But credit markets are very different from government bonds in terms of their liquidity. We see some of the star managers moving such large sums that liquidity is even a concern in normal times. What will happen to investors on their way out during stressed market conditions is hard to predict. Some of us still carry the memory of European high yield markets in the early years of this century, when liquidity dried up almost completely after years of great expectations.

The above concerns will no doubt meet expert objections from the field of fixed income fund managers. But in this epoch of the universal ‘quest for yield’, individual investors are well advised to apply their own common sense as a first line of defence. Fund costs, counterparty risk and liquidity risks are underestimated.

Without such caution, the role these funds play in an overall portfolio looks too much like picking up pennies in front of the proverbial steamroller.

Oscar Vermeulen, Director, Altis Investment Management AG