The search for yield continues, with government bonds demonstrating very little absolute return i.e. return adjusted for inflation. Contrary to popular analysis US treasuries have headed lower in terms of yield not higher, the European Central Bank has indicated that inflation has not reach its target 2%, with unemployment remaining high. Therefore both of the world’s major central banks have indicated to investors that rates will remain lower longer. Yield therefore is a scarce commodity.
What does this mean for investors, well it means that in order to enhance returns in fixed income you have to do one of three things:
Lower credit quality
The extension of maturity has been one of the most prevalent trades over the past five years ever since the ECB said they would do “whatever it takes” in 2011 investors have been benefiting from the bond purchase programs, the lowering of rates, and the reasonably steep government bond curves around the world. As a result of significant pension fund, insurance, and real money buying, yield curves generally speaking are no longer attractively steep. This negates the benefit of a maturity extension trade, and we believe could actually cause significant losses in the near future.
One of the biggest risks to fixed income investors currently is that as a result of investors extending maturities in order to take advantage of slightly higher yields in very long bonds, investors now have very high exposure to duration risk. This is a highly risky position if yields rise, and more specifically if inflation expectations are revised upwards.
I believe we are currently at a tipping point both in terms of global growth, unemployment, and central-bank action on the short end of rates.
These three factors are not currently being priced adequately into the long end of government bonds and as a result most investors portfolios having much higher duration’s than they have historically, which can and will cause significant losses when rates start to move.
Lower credit quality has been the second and also very prevalent way in which investors have generated higher yields. By moving out of investment-grade into the domain of high yield investors have added leverage to their balance sheets. The reason a BB rated security trades at a higher yield than a AA rated security is that the company itself has a much higher level of leverage and a lower interest coverage ratio than the higher-rated company. This trade is also coming to an end as spreads in sub investment grade companies are no longer commensurate with the risks of default and restructuring. Putting it in layman’s terms… investors are not being compensated sufficiently for the inherent risks in certain sub investment grade securities …..not all but some.
Lower liquidity – The concept of illiquidity premium is the third and key factor that investor should be taking into account.
The concept is simple if you lock up your money for longer you should be paid more…
We all know how bank accounts work if you have immediate access to your money every day, the rate the bank pays you is lower if they have access to your money for one year they pay you a higher rate. The same holds true with illiquid securities, investors who are involved in direct lending, private equity, and locked up structures of any sort should be and are paid more than those involved in the same credit quality companies but with no lock up and more liquidity.
It seems that this type of yield enhancement strategy also is coming to an end as the compression of illiquidity premium is at recent all-time lows, recent relative to 2008 that is. Private equity is returning high single low double digits, distressed and special situation high yield is yielding single digits, and high quality direct investments are yielding single digits.
I therefore will finish his brief article by saying that duration is not your friend, investors in high yield need to be selective about the credits they look at and not buy the whole asset class but be highly selective about the sectors, and securities that they have in their portfolios. Investors in direct investments are probably going to do well over time but they need to enter at realistic levels and make sure they are getting paid enough in illiquidity premium to be giving up liquidity in the medium-term
Once again happy to have a conversation about these topics off-line I can be reached on LG@LNGcapital.com or +442078393456