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A late 2014 Oxford research highlight titled "Chasing Yield: Buyer Beware" warned investors of the dangers in seeking higher yielding investments without a proper assessment of risk. At the time, low-yielding, high-quality bonds were a sore spot for many investors, especially those with income needs. As a result, the prices of alternative sources of income increased with demand.
MLPs, REITs and high-yield bonds were primary beneficiaries of those looking to solve the income riddle. I regularly received advertisements for investment strategies in these asset classes that invariably included simplistic comparisons of current yield – with the obvious implication that higher yield = higher return.
What was missing in these comparisons was an acknowledgement of the increased risks involved with the higher yields, especially at a time of compressed risk premiums across the capital markets. They implicitly assumed that more risk is always rewarded with more return.
Risk is an ever-present part of investing, but adding more doesn't necessarily lead to higher returns. A successful investment process aims to take well-compensated risk.
In late 2014, the 10-year US Treasury note carried a yield-to-maturity of 2.4%. High-yield corporate bonds of similar maturity offered a yield pick-up of 3.5% over Treasuries. The distribution yield on the Alerian MLP Index was 5.4% and US publicly-traded REITs offered investors a current yield of 3.6%.
These investments seemed to offer higher levels of income than Treasuries, but they carried with them significantly greater levels of risk. Worse, the risks tend to be highly correlated with equity markets while high-quality bonds are expected to retain more appealing diversification characteristics.
In all three cases, we judged the risk-adjusted opportunity in these asset classes to fall short of "well-compensated" and passed on any tactical allocation changes that included increasing or introducing new exposure in these asset classes. In most cases, the allocations to these areas actually declined during 2014.
During the last 18 months this story has started to change, and in a potentially meaningful way, thanks to increasing volatility and a broad shift in investor risk preference. True to past behavior as a desired safety asset, the 10-year Treasury yield has fallen to 1.8% over this time. Instead of 3.5%, high-yield corporate bonds now offer closer to 8.0% over Treasuries (Figure 1). MLPs, which have experienced an acute level of selling pressure due to the collapse in oil prices, trade at a current distribution rate of 9.6%. REITs have seen the least amount of change, but still price to a higher yield of 4.3%.
Source: Bloomberg, Barclays
Suffice it to say the compensation available to investors for assuming risk in yield-oriented investments, particularly with high-yield corporate bonds, is becoming more attractive. The important question to consider is – Is it enough? While it might be tempting to want to pile back in on the argument of increased yield alone, in many ways the risk assessment has become more complicated. Liquidity concerns and capital flight top the list of potential risks still facing these asset classes. The analysis required to determine if and when to allocate capital to these investments runs much deeper than a cursory glance at yield, but the increasing margin of safety is catching our attention and leading to a lot of time spent assessing these opportunities.
There will be more to come on this subject, but for now it might be time to change the sign to read: Chasing Yield: Proceed with Caution.The above commentary represent the opinions of the authors as of 2.29.16 and are subject to change at any time due to market or economic conditions or other factors. Print