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Chasing yield at the zero bound

A common analogy for a range of yield chasing strategies is “picking up pennies in front of a steam roller”. While this expression is used pejoratively – all investors, except possibly the most conservative – make risk return trade-off decisions. That is, they make decisions to chase higher returns at the cost of increased risk. In fact, today where cash rates are essentially zero, investors need to take risk to get any return at all!

This article, rather than getting bogged down on whether investors should chase yield or not (or for that matter to what extent) instead, is going to focus on a different question. That is, for different defensive investments, in today’s crazy interest rate environment, how big are the pennies and how big is the steamroller?

Measurement of risk return trade-offs can involve a wide range of statistical measures from simple means and standard deviations, to correlations, sharpe ratios, semi-standard deviations and so on. Rather than taking this approach, this article takes a simplistic approach. Across a range of asset classes I look at:

· yield to maturity;

· GFC drawdown – that is, peak to trough fall in market value during the 2007-09 global/great financial crisis period; and

· Covid-19 drawdown – that is, peak to trough fall in market value during market ructions of March/April 2020.

It is important to note this choice of measurements narrows the range of defensive asset classes that can be evaluated under this approach.

Yield to maturity (the return on a debt investment assuming it is held to maturity and doesn’t default) is only defined for debt instruments. There is no yield to maturity for equities! Thus, this article only considers debt like defensive assets – there are no infrastructure equity or property investments in my defensive assets bucket.

The universe is further narrowed by the short time period of the Covid-19 market event. To have a meaningful assessment of drawdowns, the range of asset classes considered needs to be limited to traded instruments with reasonably high frequency valuations (preferably daily). Investments that aren’t marked to market can’t be sensibly assessed in terms of a drawdown over a couple of months. Over a time period this short, the stability of unlisted asset valuations may be a measurement illusion.

[2] UBS Credit FRN 0+ Index

[3] Vanguard Australian Corporate Fixed Interest Index ETF (VACF.AX)

[4] Vanguard Australian Corporate Fixed Interest Index ETF (VACF.AX)

[5] Solactive Australian Hybrid Securities Index

[6] Elstree Hybrid Index (as Solactive Hybrid Index has inception date of 1/1/2012)

[7] Solactive Australian Hybrid Securities Index

[8] Vanguard International Credit Securities Index (Hedged) ETF (VCF.AX)

[9] Vanguard International Credit Securities Index (Hedged) ETF (VCF.AX)

[10] Ishares Global High Yield Bond (AUD hedged) ETF


[12]Ishares Global High Yield Bond (AUD hedged) ETF

The table highlights that many yield chasing strategies suffered substantial drawdowns during Covid‑19 – with losses often many multiples of the additional yield on offer. While in many cases, the strong rebound in markets has seen these losses quickly recovered, they are a painful reminder of the risks involved.

Interestingly, there is quite a variation in risk-return across the various sectors. For example, Australian corporate bonds only lost 4.4 years excess returns, compared to the much more distressing 13.4 years drawdown for global investment grade credit.

But why? What are the key drivers that make some asset classes more dangerous than others? While inevitably different people might have different views on what represents a ‘safe’ source of additional yield, it is worth looking at a couple of key drivers. To get to this – you will have to forgive me – but there is some maths.

There are two key drivers of risk – spread duration and the percentage volatility in spreads.

Spread duration is easy to understand. The market value of longer term instruments is more sensitive to changes in yields. For a given change in yields – the price of a 10 year bond is going to move roughly twice as much as a 5 year bond.

Proportionate spread volatility is more complicated. Why would different assets demonstrate different proportionate spread volatility?

To try and understand this it is important to remember why the spread exists. Spreads exist to compensate investors for the incremental credit risk and liquidity risk of an instrument. Thus, it stands to reason that instruments with more stable credit and liquidity risk should have more stable credit spreads.

To provide examples of this –

· Structured credit. For these assets, credit risk can depend on the performance of portfolios of underlying risks and securities can be effectively be leveraged to pool outcomes (think of position of BBB tranche versus a AAA tranche in the same pool). For these securities, it is not surprising to imagine a non-linear increase in credit risk during a downturn and, hence, above average proportionate spread volatility.

· Catastrophe bonds. In theory these should be the perfect uncorrelated asset – the incidence of national disasters should be uncorrelated with market downturns. However, this misses the impact of liquidity. Liquidity is related to complexity and catastrophe bonds are highly complex instruments with a narrow investor base. Thus, during a market downturn, when liquidity spreads gap wider, complex/illiquid assets suffer disproportionately.

Bringing this all together, the most attractive yield assets, under this risk/return definition, are going to be those assets with:

· Relatively low duration; and

· Relatively stable credit spreads.

Or, for those who prefer a diagram, the best risk/return trade-offs are to be found in assets that are in the lower left-hand corner of this diagram.

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