The desperate search for yield spells danger for the unwary...

Wednesday 16th August 2017

The desperate search for yield spells danger for the unwary ......

"Still crazy after falling yields" , The Economist , Finance and Economics

Some people were of the opinion that we would have turned the corner by now. Even if returns on high-grade investments are still minimal, at least the path towards an investor paradise (comparatively speaking) of rising rates and higher yields would be clear.

It hasn't turned out that way, though .....

In the US, the Trump administration's plans for the kind of tax-cutting and fiscal spending packages that would promote growth, inflation and rates have yet to materialize. We won't go off on one again , suffice to say that self-inflicted wounds have undermined support for the President even within his own party and severely hampered his ability to get anything done in Congress ..... not that an appreciation of the practicalities of government would have ranked highly on his list of attributes in the first place. If he doesn't upset too many more legislators, he should have a better chance with his next attempted bill (on tax reform) than he did on his last (healthcare). For now though, even after a rise this week 10yr US Treasuries yield 2.28%, almost 30 basis points less than they did in December.

We'll discover from the minutes of the Fed meeting to be released later today if they've got anything new to say about further rate rises and the timing of a start of Fed balance sheet reduction that should put upward pressure on bond yields, albeit in gentle fashion. In Europe, we hope to get a clue about the ECB's thoughts on the same topics at the annual beano for central bankers and high-profile financiers at Jackson Hole, starting next Thursday. The Eurozone economy is purring along very nicely but just as in the States, stubbornly low inflation numbers is making the ECB more cautious about higher rates and yields than some would like  --  Germany being the most obvious example. The 10yr German Bund still yields just 45 basis points.

By the time you've subtracted the inflation factor (low as it is) out of those kind of yields, you're looking at negative REAL returns for many high-grade sovereign bonds, and not much on the rest of them. The bond-purchasing QE programmes that depressed yields on top quality instruments have done the same thing for peripheral debt (compressing the spread between the two rates of return), and also for investment grade corporate debt. Even the junkier of junk bonds yield less than 6%. So if you're after some serious yield in the modern world, you've got to go to some pretty dodgy places to get it ...... in terms of both geography and risk.

Here's a measure of it ...... if you wanted to see a 7% return on a US Treasury, you'd have to go back over 20 years. These days, that's the sort of rate that Iraq (yes, really) pays on its 5yr paper. In fact, they were preparing to pay 7% on an issue at the start of this month, but were able to trim the coupon to 6.75% once they'd received $6bn worth of orders for their $1bn issue.

This kind of thing is no longer unusual . Greece recently made a successful return to the bond market just 5 years after it's privately-held debt was partly written off. The market couldn't get enough of Argentina's 100yr eurobond (again, yes really) in June even though that nation has defaulted on its debt six times in the previous century  --  the last time as recently as 2014. Other recent successful issuers in the eurobond market (as bonds not native to the country of issue are known) include Egypt, Ivory Coast, Nigeria and Senegal. All of these countries face a particularly difficult set of problems, none are close to being rated as investment-grade, and some have a less-than-glorious history in the bond markets, The Ivory Coast actually issued a bond in 2010 in lieu of unpaid debts, only to miss an interest payment the following year.

With the pickings so poor in safer markets, and low inflation suggesting that meaningful change may be a long time coming, it's not so surprising to see bolder investors heading into frontier markets in a search for yield. But as the Economist points out, the willingness to take on ever-riskier investments (gambles ?) does bring to mind the sort of recklessness that led to the financial crisis.. Some argue that it's the fault of rich-world central banks who have artificially suppressed yields on safer instruments for so long.

Also in the firing line are low-cost "passive" investments mangers and ETFs, which track a basket of government bonds, such as J.P. Morgan's emerging-market bond index (EMBI). The weight of money piling into these vehicles is forcing emerging market yields lower and pushing investors into ever more exotic assets. Ironically enough, "active" funds that have their own discretion over trading decisions but have fared poorly against the "passive" competition of late have also joined the bandwagon, afraid that failure to do so might mean more underperformance.

It certainly sounds like a scenario that could go wrong. There have long been frontier market specialists who know their way around the global bond market's more obscure corners, but the danger now is that the search for yield is attracting crossover investors with little knowledge and less ability to spot a potential default. These newcomers are known as "tourists", and who knows ..... they could even be tempted into local currency bond markets, which are a lot less liquid and a lot more volatile. In the case of Ghana for example, a former favourite and now in the process of fiscal recovery, these yield about 16%. That's fine if the 37% of Ghanaian public debt held by foreigners is in the hands experienced, long-term frontier specialists who are not easily spooked. If the tourists got heavily involved however ..... well, all the conditions for a nasty, knee-jerk crash would be in place.