What happens when the hunt for yield reverses?

As a final article for this quarter, how about a question on investor behaviour? The so called “hunt for yield” is the phenomenon of low interest rates resulting in investors reaching out along the risk curve to achieve their yield/return targets.

Investors who used to be happy with term deposits might switch to buying investment grade bonds. Investors who were happy with investment grade bonds might start buying junk bonds. Pension funds might reduce their allocation to cash and fixed income and allocate more to infrastructure equity and alternatives.

All of these trends, which have been going on for a decade, are a manifestation of the same thing – the hunt for yield. This has been a big driver of investor behaviour over the last decade.

What happens when base rates go the other way?

Investors who previously reached for yield can now go back to their natural risk profile.

Sounds simple doesn’t it.

But the reality is probably not so simple. Who do they sell to and at what price? In this environment, “high yield” assets could easily underperform as sellers exceed natural buyers. This leaves those who hunted for yield sitting on a capital loss (and, having a poor risk adjusted return outcome, as they took the most risk when risk was poorly rewarded).

Historically, credit spreads and base rates have been negatively correlated. That is, higher interest rates are usually associated with a strong economy and, hence, with narrow credit spreads (as defaults would be expected to be low).

However, in a rebalancing of the hunt for yield, credit spreads (and risk premiums more generally) could widen as base rates go up, compounding losses.

This will be interesting to watch, as for many portfolios, particularly the balanced options of Australian superannuation funds, the hunt for yield has been built into the very fabric of portfolio design.