O, Yield, Where Art Thou?

By: Tyler Mordy | Wed, Jan 6, 2010
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The Federal Reserve, with its ability to control interest rates and conduct open market operations ... was hailed in the 1920s as the remedy to the whole problem of booms, slumps, and panics. As a result, bankers and speculators alike were lulled into a false security which led them to operate irresponsibly, exacerbating the severity of the ensuing crisis.
- Edward Chancellor, "Devil Take the Hindmost"

For many, the phrase "where art thou", instantly evokes the balcony scene in Romeo and Juliet, with the lovestruck Juliet calling to her lover from her bedroom window. It's a poignant image. But, what many may not realize, is that the original word in Shakespeare's play was "wherefore" (meaning why) and not "where". Why did Romeo belong to the Montague family, and why did she face forbidden love?

In financial markets, investors may be feeling like Shakespeare's Juliet ... trapped in the house of ZIRP (zero interest rate policies), soliloquizing both about the where and the why of current interest rates. Where can investors locate attractive portfolio yields? And, importantly, why are longer-dated bond rates stubbornly refusing to rise materially, even as both inflation expectations and fiscal and monetary activism remain high? It's a question on every income-oriented investor's mind.

Data from the ETF space provides a partial explanation. Normally, after such a dramatic run up in stock markets, retail investors would be eschewing safe assets like bonds, and racing into all types of risky assets. After all, that's been the familiar script in recent history. Despite the popular investing advice "buy when there's blood in the streets", many investors consistently do the opposite ... choosing to buy only after optimism and rising markets have returned.

This time has been different. In a curious departure from traditional cycles, a large percentage of retail investors have not been guilty of "chasing performance", instead choosing safety over risk ... and accepting low nominal interest rates. In fact, demand for fixed income investments has been soaring. Recent inflows into bond ETFs dwarf new flows into their equity counterparts. According to data supplied by the National Stock Exchange, year-to-date cash-flows into long-only bond ETFs have surpassed USD 39 billion. The figure for long-only equity ETFs during the same period? A mere USD 2.8 billion (all values as of November 2009).

In the larger world of mutual funds, a similar phenomenon can also be witnessed. For the year to the end of November, figures from the Investment Company Institute show net new cashflows into bond mutual funds at a whopping USD 347.5 billion. Confirming the trend in stocks, a net outflow of USD 8.7 billion is seen in the total equity fund category.

Baby Boomers Exit Stage Right. What gives? Could it be the beginning of a longer-running trend ... a momentous behavioural shift on the part of individual investors? Without a doubt, spending and saving patterns in Western parts of the world are undergoing tectonic change. Both higher savings and reduced risk appetites have been evident in 2009.

As ETFocus colleague, Wilfred Hahn, recently writes, demographic trends are key to this transformation (see January 2010 Global Spin, "Zero Intolerance: Structural Reactions to Income Crisis"). Official projections confirm that the large "boomer" generation is entering the retirement phase in droves (the US Census Bureau reports that between now and 2020 the share of the population 65 or older is expected to rise from 13 percent to 16 percent, before climbing to 19 percent in 2030). Both in theory and in practice, the willingness to take risk is inversely correlated with age. But also consider that the last decade has been one of stock market turbulence (including two severe market meltdowns). Being on the wrong side of high volatility clearly has a sobering effect on risk tolerances. Combine a recent period of wealth destruction with an aging population, and it's clear that risk appetites have taken a hit.

Act II, (Re)Enter Financial Bubbles. For some investors, present market conditions may feel like an experience of déjà vu. Stock markets are again in expensive territory. And, spreads across most credit sectors now stand at similar levels seen before the collapse of Lehman Brothers in September 2008. The popular iShares iBoxx Corporate bond ETF (NYSE:LQD) has promptly returned to "pre-Lehman" levels. Yields in speculative-grade bond ETFs -- like the SPDR Barclays Capital High Yield Bond (NYSE:JNK) -- have also plunged ... providing investors with returns of over 50% since the March 2009 lows.

For retirees and the "yield hunters" of the world, this is not good news. With asset bubbles re-emerging and yield in scarce supply, adequate portfolio income is now again an endangered species and systemic risks have radically increased. For the income-oriented investor, this poses a clear challenge. Should they venture farther out on the risk curve, and risk the loss of capital, or should they settle for low, stable returns? To date, they have opted for the latter. But is that really the most prudent strategy? Let's turn our attention to the macro landscape to try to answer that question.

Confessions of a Central Banker. While financial markets have staged impressive recoveries (albeit still far below record highs set in 2008), has the real economy necessarily followed? In other words, will the tidal wave of credit creation by central banks and stimulus spending by governments be enough to support Lawrence Summers' "escape velocity" -- that is, achieve high enough stimulus-induced growth rates to drive sustainable recoveries in employment and private sector capital spending?

Of course, that is today's million dollar macro question. At this point, the jury is still out. Yet, history has consistently shown that major deleveraging periods typically take several years, not months, to resolve. Private sector debt excesses in Western parts of the world are likely to constrain overall economic growth for some time.

However, the consensus doesn't agree. Rather, there's a high level of confidence in the ability of Keynesian pump-priming to resolve today's economic problems. But historical research has shown that the so-called "multiplier" of fiscal spending on economic output is zero. In other words, short-run economic conditions may be boosted by government spending programs, but the longer term benefit is nil (research from Harvard Economics Professor, Robert J. Barro, is required reading here).

Central bankers are concerned. While they may continue to talk publicly of exit plans, they are also afraid that the recent up-tick in economic data has been driven by temporary factors. If they were convinced of a self-reinforcing recovery, the cornucopia of stimulus programs would be quickly repealed and interest rates lifted.

Pushing on a String? Indeed, policymakers are in uncharted waters ... conducting untested fiscal and monetary experimentation on a global scale. What are the key risks? For one, renewed asset bubbles are already surfacing. It is important to understand that monetary stimulus is a blunt policy tool. While policymakers may take aim at certain sectors, liquidity is not always channeled to where it is needed most. Consider that easy monetary policies have re-ignited speculative action in financial markets, yet private debt (consumer and corporate) is declining in all but one area -- securities margin debt. The latest data from the NYSE shows margin debt at USD 221 billion (up from a low of USD 173 billion in February 2009).

Secondly, risks are increasing that some economies could become unresponsive to traditional monetary stimulus (this is what Keynes meant by "pushing on a string"). Despite historically low policy rates, there is little evidence of a private sector led re-leveraging cycle in the United States and other Western countries. Indeed, most of those countries still face significant headwinds -- enormous debt overhangs, a contraction in bank lending (and the attendant reduction in the velocity of money), declining incomes and excess industrial capacity ... a concoction of conditions that is unique in the postwar period. A Japanese-style liquidity trap and renewed deflationary risks cannot yet be ruled out.

Portfolio Prescriptions. What do the above risks amount to for the income-driven investor? To begin, it's not the end of the world. But in a deleveraging environment, policy interest rates (and longer-dated bond yields) could stay lower for longer than most expect. How should we respond to these conditions?

Investors are divided. Some view the current rally in risk assets as a "rational bubble" (in the words of one British fund manager). With money artificially cheap, they argue that it is perfectly logical to pursue assets, like stocks and commodities, which are independent from governments.

Others, including ETFocus, are not convinced. Yes, governments are pursuing reckless policies. And, yes, investors will need to alter their portfolio strategies, taking a more nimble, less benchmark-oriented "eclectic" approach to investment management (even with income-oriented strategies -- see August 2009 ETFocus). But with the S&P 500 yielding under 2 percent, and according to some estimates, 35 to 40 percent overvalued, is an overweight equity position really "rational"?

Now is not the time to abandon fundamental analysis, nor a rigorous risk management framework. Staying anchored by secular investment themes and probability-weighted outlooks will always be crucial. Indeed, balanced, globally diversified portfolios remain the order of the day. Both corporate and government bonds are critical ingredients here.

Short Bonds? There is certainly no shortage of investment professionals advising a short position in government debt. A recent Barron's "Big Money" poll, showed a mere 4 percent of respondents bullish on US Treasuries. Assets in "short" bond ETFs are surging. The asset base of the ProShares Ultrashort 20+ Year Treasury ETF (NYSE:TBT) has shot up 562% over the last year. A contrarian alert? We would not be surprised if that was the case.

To be sure, we are not advocating a strict "buy and hold" policy here. Lending to the profligate US government for the next thirty years at 4.5 percent is sheer lunacy. Over a longer horizon, defaults in the sovereign debt of advanced nations are a distinct possibility. But bond yields over the next few years are likely to trend sideways ... particularly if renewed economic weakness re-emerges some time in 2010 (a scenario which ETFocus assigns a high probability).

The Japanese precedent since the early 1990s is instructive here. To counteract a period of private sector debt deleveraging, the government expanded their own debt from about 50% to over 200% of GDP. Yet, 10-year Japanese bonds spent the last several years in the 1-2 percent yield region. Why? A number of reasons, but a critical one was abundant investment demand. Domestic investors including Japan's aging population and their massive public pension fund were keen buyers of government debt. Similarly in the US, the projected supply of bonds is alarming. However, demand is also exploding with domestic investors eagerly absorbing the supply (see both chart 1 and 2).

Yield Alternatives. Domestic bonds are not the only option for income-starved investors. ETFocus has written extensively on the benefit of including international bonds in portfolios -- diversification, higher yields and potential currency appreciation. What else is available? Classically defensive sectors, like Utilities and Telecoms, have lagged the broad index and are still paying high yields. A number of niche-type assets are offering decent yields with reasonable "margins of safety". Of course, ETFs now conveniently provide access to a variety of these income-oriented asset classes.

High-quality dividend stocks are also interesting. Since the March lows, the performance gap between companies rated as low and high quality has been enormous. According to Ford Equity Research (as reported in the New York Times), which screens stocks' financial quality based on a number of factors, companies in the lowest quality quintile had an average return of 152 percent from March to the end of November. The average return for companies in the highest quality quintile? Just 66 percent ... a full 85 percentage points less. That means high quality, steady dividend-paying stocks are still a relative bargain. Stay overweight high-quality in equity components of balanced portfolios.

Star-Crossed Investors? The closing scene of Romeo and Juliet contains the other famous line in the play, "For never was a story of more woe/ Than this of Juliet and her Romeo." Yield oriented investors can relate to the "woe" in their own story -- securing reasonable income within current financial conditions. It is a serious challenge. Since the early part of this century income has been in short supply. Ultra-low policy rates sent investors scrambling for yield, creating a confusing mix of high volatility, monetary inflation and major instabilities in financial markets. Yet, investors must still continue to diversify appropriately, control emotions, and, above all, manage risk. For the current climate, staying high up in capital structures, emphasizing quality yield and a cautious stance are appropriate at this time.



Tyler Mordy

Author: Tyler Mordy

Tyler Mordy
Hahn Investment Stewards & Company Inc.

Tyler Mordy

Hahn Investment Stewards & Company Inc.
Global Fund Management & Investment Counsel
Ontario: The Exchange Tower, 1800-130 King St. W., Toronto, ON M5X 1E3
British Columbia: P.O. 2609, Station R, Kelowna, BC V1X 6A7
Phone: (888)-957-0602 e-mail:information@hahninvest.com

Tyler is regarded as a leading expert in the burgeoning field of exchange-traded funds (ETFs) and writes an influential, bi-monthly publication called ETFocus. He is a recognized innovator in the design and application of actively-managed ETF portfolios. Tyler's expertise is widely acknowledged, and he has been interviewed by several notable publications including The Wall Street Journal's - Smart Money and City Wire - Guide To Exchange Traded Funds.

Tyler Mordy is a portfolio manager and Director of Research at HAHN Investment. Since joining the firm in February 2003, he has made key contributions in the development of the firm's proprietary portfolio systems. A member of the HAHN Investment Committee, he is engaged in top-down strategy, investment policy and securities selection.

Previously, Tyler began his career at Deutsche Asset Management in London, UK. He earned his bachelor's degree in both Mathematics and English Literature at the University of British Columbia. Mr. Mordy is a CFA charterholder.

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