With the dramatic fall in interest rates around the globe, investors have been searching for assets that will generate the necessary income to meet their future cash-flow needs.
This pressure has led to what many are starting to term a desperate search for yield or, even worse, a yield bubble. What originally started as investors moving from high quality bonds and term deposits into riskier bonds such as high yield credit, emerging market debt and junk bonds, has now moved on to heavy investment into high dividend paying stocks and hybrids.
As investors’ fixation with yield becomes stronger and they invest more into equities and bonds with equity like attributes (such as junk bonds and hybrids), some lose sight of the impact that valuations and capital volatility will have on future returns. While these assets have a place in a portfolio, some invest in these assets without necessarily understanding the risk versus return tradeoffs.
It seems that for many investors, the Global Financial Crisis (GFC) is a thing for the history books. Let’s not forget however, that some of these high yield fixed income sectors fell over 17% in one month alone during the worst of the GFC. Although these were extraordinary circumstances and liquidity was at a premium, those investors who had taken the opportunity to ‘bump’ up their income were shocked, to say the least.
Therefore, it is always important to remember that as a result of their risk characteristics, high-yield bonds often end up behaving more like stocks during turbulent times; this is reflected by the relatively high correlation between some segments of the fixed interest market and equities. While we are not necessary suggesting there will be another GFC, investors have hopefully learned the lessons of the last GFC and importantly, that there is no such thing as a free lunch.
It is also important to make a distinction between yield and income. Many investors interchange these terms, however they are not the same. Yield is directly related to asset prices i.e. yield can go up, not only due to an increase in the level of income being distributed, but also as a result of a decrease in the asset price of a security. Effectively this can result in yields going up, but income (or the cash payment) remains steady or might even decrease due to a fall in the value of the asset base. This distinction is particularly important for the retirees who require a steady income stream in retirement.
Amanda Gillespie is the Chief Executive Officer of Lonsec Research
