Finding your way through a low-yield environment
With yields in five years’ time likely to be significantly higher than they are today, fixed income investors need to carefully monitor their portfolios, as the risk of mark-to-market losses is high.
In the aftermath of the Great Financial Crisis, the then governor of the US Federal Reserve, Ben Bernanke, slashed interest rates to zero in order to foster credit demand. He then focused on forward guidance: the most revolutionary proposal was the purchase of government bonds with the intention of lowering the yield level on a permanent basis. The unlimited provision of liquidity ‘for free’ has helped to restore net wealth, confidence and, ultimately, the purchasing power of both households and companies.
Yet this low-yield strategy has also come at a price for bond investors. Investors in the fixed income segment are not receiving decent compensation for lending in nominal terms, and in real terms they are realising a loss. The example of the United States shows that the process is, however, reversible, and it will be in most cases. Nevertheless, investors must be aware of the consequences of the ‘normalisation of monetary policy’ and its impact on their bond portfolio.
What is yield?
Put simply, the yield is a person’s return on their investment, and it is broadly made up of compensation for the postponement of consumption, for inflation risk and for the risk of a fall in the value of the investment. Let us start by considering consumption. Consumers generally have a positive rate of time preference – this means they place a higher value on consuming something now than they do on consuming the same thing at some point in the future. When people invest money, they are in essence delaying the time at which they can use that money, and the yield on the investment must compensate for this.
Nominal versus real yield
Inflation, although its magnitude varies, is a normal feature of an economy. The return on an investment must therefore also incorporate compensation for expected future inflation (i.e. an inflation premium) in order to prevent a decrease in an individual’s purchasing power. With this in mind, it is important to distinguish between nominal and real yields. The real yield takes the effect of inflation into account, while the nominal yield does not. Inflation eats into the value of the principal repayments as well as the future coupons. Therefore, the real yield is more useful, as it better reflects the additional purchasing power gained as a result of the return generated on the investment.
The trade-off between risk and return
In addition, all investments come with a degree of risk that their value will fall over time, and this must also be taken into account in the return (i.e. the risk premium). Broadly speaking, investors face a trade-off between risk and return: in order to potentially achieve a higher return, an investor must take more risk. In the same way, if an investor would like to reduce the level of risk in their portfolio, they must also accept a lower return. That said, the fall in yields on fixed income investments over the last several years has been due to central bank policies and not due to a change in the risk level of these investments. Consequently, fixed income investors today are receiving a lower yield on their investments, while the risk they are taking has not changed materially.
Why do the rates set by central banks matter?
The deposit rates set by central banks are the key determinants of all other interest rates and therefore have an impact on consumers and businesses too. The negative or low interest rates maintained by many central banks in recent years have also had an impact on bonds, particularly short-term bonds. The yield curve is a graphical representation of the yields available on bonds of a given issuer across various maturities and at the short end, the yield curve is dragged down by zero or negative deposit rates. This explains why the yield on short-dated bonds in recent years has been exceptionally low.
What does inflation mean for fixed income investors?
Inflation matters because when the prices of the goods and services that we consume go up, if our income stays the same, we can afford to buy less. It also erodes the value of our savings, as the same amount of savings would buy us less now than it used to when prices were lower. In terms of fixed income investments, inflation reduces the future value of the principal to be repaid on a bond as well as the future coupon payments; it is therefore critical that current inflation expectations are considered when analysing the appeal of a fixed income investment. On the assumption that investors are seeking a specific real return (taking inflation into account), if expected inflation increases, then the nominal yield on a bond must also increase for the same investor to want to buy the same bond.
Why is the current setting so challenging?
The low or negative interest rates set by central banks over the last several years have resulted in a very low-yield environment. Many investors have consequently looked further afield for opportunities to earn an enhanced yield. These higher-yielding alternatives include corporate bonds, high-yield bonds, emerging market bonds and high-dividend stocks, all of which are riskier than short-term government bonds. As a result, ‘accidental high-yield investors’ have appeared, i.e. investors who previously would not have sought to take this much risk have increased the risk level in their portfolio in seeking to earn a higher yield or generate a higher income from their fixed income investments. In some cases, this may have been an appropriate adjustment, while in others, the risk level may have hit levels higher than those suitable for a given investor’s individual circumstances. Furthermore, as corporate leverage has increased, credit spreads have become tighter, and thus the compensation received by investors for the credit risk they are taking on is at multi-year lows.
Negative interest rates are not yet a thing of the past
The Fed hiked interest rates for the first time in ten years in December 2015. Since then, they have continued along a path of gradual monetary policy normalisation. However, interest rates in the US are still only rising slowly and are low when compared to historical levels. Furthermore, in the eurozone, Switzerland, Sweden and Denmark, the deposit rate is still negative, while in the United Kingdom, the Bank of England has set rates at the relatively low level of 0.75 % (at the time of writing). As such, the phenomenon of negative or low interest rates is not yet a thing of the past. Nevertheless, the process of interest-rate normalisation has begun, and investors must therefore also consider the risks of being invested in the fixed income space during a period when interest rates are rising.
How a fixed income investor should act in an environment of low yields but gradually rising rates depends, of course, on why an investor is holding bonds in their portfolio. However, with yields in five years’ time likely to be significantly higher than they are today, fixed income investors need to carefully monitor their portfolios, as the risk of mark-to-market losses is high.