The perils of (over) stretching for yield

Working from home has greatly reduced my daily level of activity. The thousands of steps I once took per day in the daily bustle of commuting has dwindled to hundreds, if I’m lucky.

With physical fitness falling to the wayside, it’s a wonder that I haven’t stretched a muscle reaching for the banana bread.  The similar risk looms for investors, of sorts. Not gluttony, but rather the risk of overreaching. Investors who overextend themselves to find income might unknowingly add to unwanted portfolio risks in the drive for yield. 
To understand this risk, it’s helpful to understand that markets themselves are currently somewhat overstretched, in terms of being at extreme levels relative to their own history.

In the last few weeks, investors fearful that the pandemic would cause the prices of riskier assets like stocks to fall, took shelter in lower risk assets, like government bonds. As a result of this heightened demand, bond prices, which move inversely to yields, soared. Central banks, who pledged to support economies globally by flooding financial systems with liquidity, further fuelled that rally by promising to buy more government bonds, further driving up prices. This price movement resulted in capital appreciation for bondholders, but it also reduced the level of income payout to investors. 

Where does that leave us now?  Bond prices have rallied handsomely through this crisis and they are now incredibly expensive. At these eye-watering levels, investors may not fully grasp how painful it would be if yields were to spike back up (i.e. if prices were to fall). Because they’re no longer getting much income from these bonds, that would make capital losses all the more painful for investors. 

For example, the longer the duration of a given bond, the more sensitive to interest rates it is – theoretically a 1% increase in interest rates would equate to a loss of approximately 11% in total return terms on a 10-year Australian government bond at today’s yields.  

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All this highlights the clear need to be mindful of duration risk and potential capital losses on government bonds. While having exposure to more conservative assets like bonds should remain an important part of a balanced portfolio, especially in an environment where clear policy support from central banks will continue to bolster bond prices, investors should also be awake to the risks.  

QUANTITATIVE BY NAME, NOT BY NATURE

Simply put, the actions taken by central banks to shore up economies around the world have had seismic implications for bond markets. In doing this, central banks have once again proven their worth as today’s modern financial heroes. Their swift and sizable actions restored market confidence and inspired the market rally we’ve seen since late March. 

A number of central banks have started, or reignited, programs designed to inject money into the economy and expand economic activity by buying up government bonds or other financial assets, known as quantitative easing (QE). In reality, these new QE policies are really not quantitative at all, as the uncapped nature of bond purchases being undertaken by the world’s largest banks is focused on providing financial stability and liquidity. These QE policies aid market functioning and help to lower the cost of cash in the economy as interest rates fall to zero, or as close to zero as they will get, in many economies. 

With all this buying of bonds, the ballooning size of central bank balance sheets will dwarf anything experienced in the numerous rounds of QE since the Global Financial Crisis (GFC). Already this year, the US Federal Reserve has purchased more than $1.5 trillion in US Treasuries, equivalent to 7% of its gross domestic product, and over $500 billion in mortgage backed securities, eclipsing the total purchases that were made under the first three rounds of QE up to 2010.

It’s not just the big players either –the Reserve Bank of New Zealand has purchased government bonds equivalent to 10% of the size of its economy.

This monetary support being offered by central banks is entwined with so-called fiscal support, meaning stimulative spending or policies enacted by governments to try to counteract the economic fallout of the virus containment measures. 

Put another way, if central banks are the lenders of last resort, then governments are the spenders of last resort. That spending by governments, funded by borrowing through issuance of debt, has been made quite affordable by low interest rates.

As economies try to recover from lockdowns, continued support – buttressed by government debt – is going to be needed for a long time. In other words, we will see more central banks financing government deficits directly by buying up new debt issuances.  

CREDIT WHERE CREDIT IS DUE

As part of their expansive measures to cushion the economic consequences of COVID-19, central banks’ monetary policy toolkits continue to expand, providing support for areas of the fixed income market outside of just core government bonds. A plethora of new and revised initiatives announced by the US Federal Reserve since March have extended the Fed’s reach into the corporate bond market (i.e. into so-called credit assets). 

Two key Fed programs are the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). As the names suggest, these two initiatives will purchase bonds directly from investment-grade issuers as well as buying bonds that are already trading on the secondary market. The goal is to improve market liquidity and to reduce the difference in yields between government bonds and corporate bonds (known as credit spreads). Importantly, in the case of the SMCCF, the Fed will dabble in the high yield bond market, which is a significant departure from their traditional involvement. 

The outcome of all these initiatives has been to lower the yields, or narrow the spreads, on corporate bonds, greatly reducing levels of market stress. Bond credit spreads act as a kind of thermometer for economic health – narrowing credit spreads tend to be a good indicator. 

STRETCHING, BUT NOT TOO FAR

Pricing that is responsive to central bank intervention in bond markets, and subdued economic activity as we recover from the virus, mean that investors should remain focused on quality in fixed income markets, continuing to lean into sectors that come under the wings of central banks. 

Core government bonds may no longer offer up a strong level of income – or possibly none when adjusted for inflation – but their role in portfolios is still important. It would be remiss to abandon the diversification benefits of holding government bonds as a core diversifier given the still unknown risks to the outlook.

The higher-grade corporate bond market (i.e. higher-quality bonds) is where investors can find a reasonable income and the benefits of the central bank safety net. But not all bonds are equal. Extreme periods of stress and then recovery, as experienced in the past few months, mean that both good and bad securities rode the wave higher and lower.

As a result, less credit worthy companies with weaker balance sheets may have had their corporate life extended, but this does not make them worthy borrowers or worthwhile investment choices. 

A focus on quality and resilient business is key to picking the right bonds to invest in during a still uncertain environment. For income seekers, this means a bottom up approach in locating corporate bonds that are backed by companies with stronger balance sheets and the ability to operate throughout a potentially longer downturn. Enormous monetary support may initially stave off some corporate defaults, but riskier credit securities, such as those backed by weaker businesses, will not be fundamentally strengthened in the long-term. Nowhere is this truer than in the high yield sector of the bond market.

Before COVID-19 was a common household term the high yield market looked to be an attractive source of relatively higher income in the bond market, because even less credit worthy companies were still likely to be able to pay back their debts, meaning a low default rate.

However, the COVID-19 induced recession and the fall in oil prices, which disproportionally impacts US high yield companies in the energy sector, has materially changed the risk-reward dynamics in high yield bonds. In other words, although these securities look like attractive sources of income because of their high yields, they may be too risky for many investors. 

THE SILENT KILLER

Of course, the great enemy of bond investors is inflation. This silent killer lurks in the background, slowly eroding the purchasing power of our money over time – making today’s money worth less in the future. This is why we need our investments to deliver returns that outperform inflation — what’s known as a ‘real’ or inflation-adjusted return. Indeed, given low interest rates, real yields today on government bonds in the US and Australia are negative when adjusted for inflation. 

The great debate is whether the trillions of dollars of fiscal and monetary stimulus will eventually result in higher rates of inflation. The general prognosis is that the recession will be shorter than average given the nature of the shock, and that the sudden stop to many economies could soon be reversed. Nevertheless, the legacy impact of monetary and fiscal policy stimulus will act as a tailwind for some time to come, potentially leading to an overheating economy and higher inflation. 

However, given that inflation did not materialise in the aftermath of the policy response to the GFC, it’s difficult to see the current situation being different. There may be spikes in spending as individuals and households once again find their freedom, but spending patterns may change and savings rate increase over the long term, leading to lower rates of consumption overall, thereby keeping inflation in check.

Uncertainty over the path ahead will be with us for some time. To navigate this and keep their portfolios on track, investors should focus on those companies with the resilience to withstand the economic fallout. This means a focus on quality when thinking about income from bonds, as well as investing in bond securities that are beneficiaries of central bank purchases.

To make the most of the opportunities, however, being bound to one sector means the potential for missed income in others. A better approach for bond investors may be to focus on the opportunities presented across all segments of the global fixed income market. This may not sound very exciting, but bonds aren’t meant to be.  

Kerry Craig is a global market strategist at J.P. Morgan Asset Management.