Reach For Yield – John Bull Can’t Stand 2 Percent: QE’s Depressing Implications For Investment
George Washington University – Department of Finance; The Carlyle Group, L.P.
March 25, 2016
Much of the existing literature misunderstands “reach for yield” behavior as an increase in risk-taking in response to low interest rates. By focusing on common stocks – where dividend yields are inversely related to systematic risk – I demonstrate that “reach for yield” instead reflects an increase in the marginal utility of current income relative to expected holding period returns. The monthly returns of the highest yielding 10% of stocks increase by 0.76% for every 1% decline in two-year interest rates, after controlling for known risk factors. The monthly returns of a long-short portfolio that buys the highest-yielding 10% of stocks and sells the lowest-yielding decile increase by 1.4% for every 1% decline in two-year interest rates. These effects are three-times as large when the decline in interest rates is attributable to a fall in the term premium, which suggests unconventional monetary policies may generate especially large increases in the marginal utility of current income. By increasing the market value of current income relative to future returns, unconventional policy may lead corporate managers to boost shareholder distributions at the expense of capital accumulation.
Reach For Yield – John Bull Can’t Stand 2%: QE’s Depressing Implications For Investment – Introduction
Much of the existing literature misunderstands “reach for yield” behavior as an increase in risk-taking in response to low interest rates. I demonstrate that the “reach for yield” instead involves portfolio shifts towards assets that generate more current income. This is an important distinction, as yields and expected holding period returns can differ substantially. When the utility function of the representative investor includes a preference for current income, portfolio choice is not limited to the marginal rate of substitution between mean (expected return) and standard deviation (risk), but also the substitution between assets that offer higher yields today relative to those with higher expected returns over the entirety of the investment horizon.
Evidence of a “risk-taking” channel of monetary policy comes predominately from fixed income markets where yield is a function of the conditional volatility of returns. This relationship does not always hold. I demonstrate that the risk-taking channel disappears when the portfolio choice problem is opened to asset classes where yields and conditional volatility are not correlated, like common stocks.
It is well known that some investors, such as seniors, prefer assets that generate current income (coupons, dividends, rents) to those assets with higher expected returns (Miller and Modigliani, 1961). I demonstrate that low real interest rates change relative prices in the aggregate by increasing the marginal utility investors derive from current income. Contrary to the predictions of the “risk-taking” channel, investors respond to low rates by increasing exposure to low beta stocks, reducing systematic risk in the search for additional yield.
I show that the relative price of dividend-paying stocks depends on the level of real interest rates and monthly returns on high-yield stocks vary in response to changes in policy-sensitive Treasury yields. The higher the dividend yield on a portfolio of stocks, the greater the sensitivity of its monthly returns to variation in interest rates. The monthly returns of a portfolio of the highest-yielding 10% of stocks increase by 0.76% for every 1% decline in two-year interest rates, after controlling for known risk factors. A long-short portfolio that buys the highest-yielding 10% of stocks and sells the lowest-yielding decile generates monthly returns that increase by 1.4% for every 1% decline in two year interest rates.
Interestingly, when the decline in two year rates is attributable to a fall in the term premium, the increase in the return on the long-short portfolio is over three-times as large. Monthly returns on the long-short portfolio rise by 4.2% for every 1% decline in the term premium, as measured by Adrian, Crump, and Moench (2013). Unconventional monetary policies like quantitative easing (QE) and forward guidance that suppress term premia may generate especially large increases in the marginal utility of current income.
If “reach for yield” involves a preference for current income rather than a change in attitudes towards risk, unconventional monetary policy could potentially depress business investment by increasing the market value of shareholder distributions relative to the expected returns from long-lived capital. Some commentators have suggested that unconventional monetary policy makes business managers more inclined to repurchase stock rather than invest in productive capital (Spence and Warsh, 2015). Unfortunately, explanations for this behavior rely on assumed frictions that somehow make corporate equities less risky than the underlying corporate assets, or generate otherwise inexplicable departures from the standard results of state-based asset pricing models.
I demonstrate that one does not need to rely on fantastical assumptions to understand why unconventional monetary may depress business investment. Production-based asset pricing models in the spirit of Cochrane (1991, 1996) make no distinction between real and financial assets. The corporate manager is assumed to pursue an investment policy that maximizes the present value of the stock price of the business, which is tied through arbitrage to the state-based payoffs of its assets. If a negative shock to real interest rates increases the representative investor’s marginal utility of current income, the corporate manager would be expected to reduce planned investment in favor of higher current shareholder distributions. Such a result would be consistent with Baker and Wurgler (2004), who find that the decision to pay dividends is driven by investor demand.
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