In the search for yield, we do not indiscriminately favour higher yielding securities. Rather, we aim to identify the sweet spots across the risk-return spectrum with a preference for low-investment-grade and better-quality (Asian) high-yield bonds, unconstrained fixed-income strategies and, on a selective basis, stocks and equity-like instruments.
Generations of pupils are taught that investors want to be compensated with a positive expected return on an investment
1) to offset the risk of a loss on the principal,
2) to counteract the corrosive effect of inflation and
3) to justify their decision to postpone consumption in favour of the investment.
Upon entering the work force, they enthusiastically put to work what they have learnt.
Financial markets force us to stay humble
However, when theory meets practice, the importance of life-long learning becomes utterly visible. In September 2019, nearly USD 17 trillion of bonds – an amount just shy of the annual output of the US economy - were offered at negative yields. Thus, investors buying these securities and holding them to maturity would have a sure loss.
While the volume of negative yielding bonds has fallen to around USD 11 trillion, it is still at very high levels from a historical perspective. This is because financial repression – please see info box below - continues to keep much of the developed world in its grip and as a consequence, interest rates low.
Info box: Financial repression and low interest rates
Financial repression describes a variety of policies and means through which market forces are distorted by regulation and interventions, often leading to governments effectively transferring wealth from the investing public to the public sector. Today, financial repression can be observed in much of the developed world where household wealth is eroded by historically low or even negative interest rates and extensive bond buying programmes by central banks. As a consequence, in many countries around the world, cash-like investments no longer compensate investors for inflation. In other words, savers are left with negative real interest rates.
Thus, while these policies of financial repression started as emergency measures to combat the great financial crisis, they have become deeply ingrained in our financial system as growth remains anaemic, inflation dormant and all the while public debt is soaring. We note a growing public unease about financial repression and outright scepticism about its effectiveness. Thus, the voices demanding more fiscal stimulus are getting louder. In fact, effective government stimulus measures and increased deregulation would also reduce the need for artificially low policy rates, bond yields and government bond purchases. If you are interested in learning more about this topic, please see the CIO Monthly: The basics of asset allocation from our Chief Investment Officer Yves Bonzon.]
Even the expected growth pick-up this year is unlikely to unleash higher policy rates as we do not see concrete and effective fiscal stimulus measures being launched this year (particularly in Europe). Therefore, we expect the current low-interest rate environment to prevail.
Unless governments fire the magic silver bullet (of fiscal stimulus) to spur growth, negative interest rates will not go away. In the meantime, alternatives to non-yielding assets will thrive.
Where to look for yield?
The world economy was fuelled with cheap money in 2019 and the economic cycle should last well into 2020 as our Head of Research, Christian Gattiker, and Mark Matthews, Head of Research Asia, outline in our Outlook 2020. In this context, we have a preference for taking measured credit risk via low-investment-grade and better-quality high-yield bonds. However, we would avoid structurally weak sectors in the search for yield, such as brick-and-mortar retail chains that are being challenged by the growth in online sales. At the same time, given our expectation of higher long-term interest rates, we see little value in taking on duration/interest rate risk.
Beyond this core focus, we see select opportunities across the risk-return spectrum:
Asian high-yield bonds: In emerging markets, we have a preference for Asian credits due to the region’s solid growth prospects. In addition, many local firms pay relatively attractive yields, while being less leveraged than many of their developed market counterparts.
Unconstrained fixed-income strategies: This type of strategy is not tied to any benchmark; thus capital can be allocated to those markets deemed most attractive. In combination with this strategy’s ability to manage interest rate risk actively, it has the ingredients in place to generate attractive returns in the prevailing low-interest rate environment.
Equity-sensitive exposure: Investors with a higher risk tolerance can consider diversified, actively managed subordinated bank bonds issued by solid financial institutions. This segment should benefit from an ongoing build-up of capital at financial institutions, overall better asset quality and positive regulatory developments. In addition, value stocks with robust and rising dividends are attractive, especially compared with highly speculative bond issues.
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