With interest rates at historic and unprecedented lows, the temptation to “reach for yield”, the propensity to buy riskier assets in order to achieve higher yields, is greater than ever. Unique challenges and constraints pose significant difficulty in maintaining proper portfolio diversification and risk mitigation while looking to replace income from traditional asset classes.
Prior to the financial crisis of 2008-2009, higher quality fixed income assets primarily consisting of Treasury, municipal and investment grade bonds were standard components of investor portfolios offering adequate and reliable income as well as risk protection and safety. US 10-year Treasury bonds had rarely traded below 4% prior to the financial crisis while representing the ultimate of safe havens. Such asset classes provided necessary diversification in their inverse correlations from equities, inherently hedging portfolios as fixed income prices traditionally rose to offset periods of equity declines. But since the turn of the century, interest rates have steadily declined, resulting in a lengthy and prolonged low interest rate environment that has presented investors with a unique and unprecedented challenge in finding the increasingly elusive combination of income and stability that had always been prevalent in fixed income asset classes.
Modern Portfolio Theory is the quantitative analysis of how portfolio diversification can simultaneously maximize returns and optimize risk, acknowledging the direct relationship between risk and reward and their effect upon one another. Accordingly, it had become widely accepted that the ideal portfolio to balance risk and reward most favorably was a blend of 60% stocks and 40% bonds. The stock and bond allocations of the proposed portfolio were broad based and inherently well diversified in focus, representative of the S&P 500 and the Barclays Aggregate respectively. While the fixed income portion of the portfolio was meant to mitigate risk with its inverse correlation to equity performance, it was also assumed to be providing significant income with at least 5% yield. Unfortunately, fixed income rates have dropped precipitously in the past 20 years as we’ve been locked in an extended and enduring low interest rate environment. As global bond yields have recently plummeted to zero or lower, capital returns and income from bonds can no longer hedge against losses in stocks the way they once did.
The total return of the Barclays Aggregate over the past 15 years is 4.29%, and currently yielding a mere 2.53%. (1) The fund is considered the hallmark of conservative fixed income investing and maintains over 72% of assets in AAA rated issues. Even to maintain a respectable yield in such a low interest rate environment, the AGG has increased credit duration significantly over the past decade, making it more sensitive to interest rate risk. With the US 10-Year Treasury yielding well under 1%, and AAA rated 30 year municipal bonds yielding well under 2%, it becomes readily apparent that the traditional fixed income piece of optimally diversified portfolios is not going to be capable of achieving what it was meant to achieve. While it may continue to provide a formidable hedge against equity declines, it is not coming anywhere even close to providing the income that these portfolios are relying upon. As this situation has progressed for the better part of two decades at this point, the search for income has led many investors to start “reaching for yield”.
The problem with “reaching for yield” is that in reaching further and further, such stretching comes with more and more risk. Suddenly, almost immediately, that perfect optimization between asset classes no longer exists. The lower correlation amongst asset classes disappears, disrupting the ideal balance that had existed. While it’s possible to replace the lost income with different asset classes, it’s only being accomplished by incorporating significantly more risk. In fact, pretty much the only place that you can get a greater than 5% yield in the fixed income markets right now is with low investment grade speculative issues, aka “junk bonds.” While Junk bond bellwethers such as SPDR Bloomberg Barclays High Yield Bond ETF (JNK) are yielding over 6%, that increased yield is being generated by companies whose credit and financial status are much weaker. In fact, Moody’s Investor Services Rating Agency recently warned of as high as 10% default rate among this category of investments.(2) In comparison to a much more conservative Barclays US Aggregate, with mostly AAA rated companies indicating the highest credit quality with almost no risk of default, junk bonds are offering an extra 4% to invest in companies with moderate to weak ability to meet financial requirements. Moreover, the inverse correlation that is favored between stocks and bonds is lost. Where risk mitigation is optimized by bonds showing positive returns when equities show negative returns and vice versa, junk bonds tend to move in line with equities. Is it worth it to reach for the extra 4% given the increased risk? Not from a portfolio optimization perspective that relies upon a symbiotic relationship between equities and fixed income, as the balance between minimal risk and maximum return has been upended.
Ultimately, reaching for yield in an enduring low interest rate environment becomes very challenging with fixed income as the options become limited to increasing credit risk and increasing duration. Unfortunately, the latter of these two options isn’t going to have much of an effect on increasing income in the current environment. Outside of increasing credit risk in bonds, the search for yield ultimately opens the door to the inclusion of other asset classes. Innovation and creativity with alternatives to fixed income is acceptable provided that the investments being used in lieu of bonds are still providing the safety of traditional fixed income. For one, an increase in equity percentages may be justified if the complementary fixed income piece is adjusted to be more conservative. In such a scenario, additional risk is taken on in seeking a higher return by increasing the percentage of allocation to equities, only to be mitigated by a more conservative fixed income allocation which is perhaps shorter in duration or composed of higher credit quality. This has proven favorable in the past decade from a growth perspective, but still leaves challenges in generating income. From that perspective, the incorporation of higher-yielding investments such as private equity, hedge funds, credit funds, REIT’s and other types of alternatives including structured products and different types of annuities may serve a critical role in enhancing income while managing risk.
Reaching for yield, in and of itself, is not the problem. In theory, it is a very rational and sensible thought process in that there is an implicit understanding that something needs to be corrected or enhanced to perform better. This is not to say that there is no danger involved, especially if proper diligence and prudence are not exercised. The negative consequences of incorporating higher yield investments arises when they come at the cost of less portfolio diversification and a higher correlation to equities. While modern portfolio theory has always espoused the virtues of a 60-40 portfolio as being representative of the ideal risk/reward ratio for investment portfolios, the optimal percentage allocations are actually much more variable from a wealth management and financial planning perspective given the unique and subjective nature of client objectives, risk tolerances and time horizons. While there’s no perfect portfolio, there is a perfect portfolio for each investor. And for each portfolio there exists an “efficient frontier” with maximum expected returns calculated for any given risk level. This optimization can only be made successful when diversification amongst asset classes is employed properly. When “reaching for the yield”, successful outcomes will be determined through strict adherence to appropriate portfolio diversification and proper correlation of asset classes.