Yield Chasing Guest post by Jonathan Rochford, CFA Portfolio Manager of Narrow Road Capital Pty Ltd
August was a mixed month for risk assets with the credit the best of the major asset classes. China (3.9%), Japan (1.9%) and Europe (1.1%) saw gains on stocks, but the US (-0.1%) and Australia (-2.2%) went backwards. Commodities mostly fell with the Bloomberg commodities index down 1.8% driven by falls in copper (-6.5%) and gold (-3.2%). US oil bucked the trend surging 7.8%. Emerging markets mostly rallied with strong flows boosting equities and debt.
The key theme for August was yield chasing, with evidence of it seemingly popping up everywhere. Articles from UBS and BAML pointed to this in the credit markets, with the Wall St Journal noting that catastrophe bonds are another area that has seen spreads fall sharply. European coco’s are back in favour with recent sales seeing order books ten times the size issued. The fears earlier this year that Deutsche Bank would have to skip payments and the expectation that Bremen Landesbank will skip its payments shortly haven’t turned off yield starved buyers.
To get just a little bit more yield foreigners are going long duration in US debt. Japanese investors have been fleeing their home market and its negative yields withUS mortgage debt the latest target. Money is going the other way though, with Pimco and Chinese investors buying Japanese bonds as after they include the pick-up from the currency swaps they are getting positive yields. If you want to understand why this is happening here’s one investor explaining why he is buying preference shares because bond yields are so low. If you are tempted to join the herd here’s five reasons not to chase yield.
The gold medal article on yield chasing included the following quote: “Which is riskier, buying a double-digit yielding sovereign bond or buying a negative-yielding government bond? I’ll take the yield any day, knowing that there’ll be some volatility but knowing that over time you’re going to make a lot of money.” The portfolio manager at Legg Mason is right in the short term, that trade will generate more yield. But if the bonds default and he gets a 10% recovery rate he and his investors will learn that there’s no free lunch.
Behind the yield chasing lies central banks, who haven’t yet realised that the drugs don’t work, they just make it worse. Central bankers are from the same group that brought us LTCM; academics without market experience. They rely on models and untested theories rather than opening the window of their ivory towers and seeing the havoc they have created in markets. The Chairman of the Rothschild Investment Trust labelled central bank actions “the greatest experiment in monetary policy in the history of the world”. One headline on Bloomberg illustrates the problem, “Central Bankers Spurn Call for Radical Approach at Jackson Hole”. A rational person would take that to mean dumping negative interest rates and quantitative easing, but no, those policies are only considered “unconventional” now.
The enormous purchases of government and corporate debt is crowding out European investors, who’s capital has to head elsewhere. This cascades through investment grade debt, high yield debt and then to equities. When combined with low reserve rates asset valuations get pushed ever higher. A real estate mogul noted the impact of cheap debt and said that US real estate is “bubblicious”. Citibank detailed six ways that central banks have distorted markets.
Central banks are no longer just part of the investment environment, they have become the key factor in it. Investors no longer just ask what will Janet Yellen do, but what can she do without wrecking the global economy. High yield and emerging market debt sectors are already unstable. A series of interest rate increases could kick a leg out from under those chairs. It’s not surprising that many investors have concluded that rates will never increase materially, because the damage would simply be too great.
Another key theme for August was the very low levels of volatility. Jesse Felder noted that short volatility positions could be wiped out with one day of large falls. Most would take that to mean that now is a terrible time to be selling put options, but US pension funds are doing that as a new way to generate returns. Over a cycle, selling options and being long volatility pays off. But for a pension fund it means that you are even more exposed to the downside, particularly if there’s a sharp sell-off. It looks like a double or nothing proposition, to cover the underfunded position more risks are taken but if assets sell-off the underfunded position get an awful lot worse.
In a world where interest rates are trending lower the recent spike in LIBOR is notable. Some view it as concerning as a spike in LIBOR preceded the last financial crisis. This time it seems there’s a basic explanation for the increase. The strange beasts that are US money market funds are undergoing reforms that require daily mark to market on unit prices, unless all the securities owned are government debt. That change has seen a major shift out of commercial paper issued by corporates to short term treasuries. As a result of the loss of buyers the interest rate benchmark for those securities, LIBOR, has jumped. There are differing views on whether the higher levels will hold or whether supply and demand will balance in future months and LIBOR will then drop back down.
In the short term this is bad news for corporates and banks that rely on LIBOR linked securities for funding. They will most likely shift to issuing longer term fixed rate bonds, which is better for their liquidity profiles and will have a more stable interest rate. It also impacts some leveraged loans, which pay a margin on top of LIBOR. However, as 91% of leveraged loans have some form of LIBOR floor not many will have seen a material interest rate increase. The biggest losers appear to be Asian debt markets and CLOs. CLOs have seen their net interest margins squeezed as the interest rates they pay increases, but the interest rates they receive largely hasn’t. This is another concern for CLO investors, in addition to the increasing number of defaults and lower recovery rates.
Yield Chasing – High Yield Debt
There’s been many warnings on US high yield, with detailed analysis from Marty Fridson well worth a read. The numbers are simple; margins have fallen whilst defaults are rising and recoveries this cycle are particularly ugly due to the near wipe-out results common for defaulting energy companies. Without a dramatic lift in oil and natural gas prices, many more energy credits will default. Fitch has 49% of their “loans of concern” list from