The Search For Yield

The effect of quantitative easing on asset yields is clear. When central banks buy bonds and other private sector assets, they bid up the price and push the yield down.

Last week, junk bonds in the United States dropped below 5% yield. This is because when almost every other asset class has a low yield, anything with a higher yield will be purchased by those who need to own assets with yield.

Pension funds in the United States have substantial unfunded liabilities becaused they are “defined benefit” retirement schemes. These corporations, states and unions made promises to their members. They have suffered investment losses and thus need to earn more than the market is currently offering if they want to have any hope of reaching the level of assets needed to deliver on promises made in the past.

The search for yield in the current low interest rate environment presents a whole new level of risk. Higher yields are traditionally linked to higher credit risk if we are talking about bonds. But if high risk bonds suddenly become low yield as a second-order effect of quantitative easing, then there is effectively a mis-pricing of risk.

What this does is create a dilemma for the bond markets. If lower yields let more bonds into the “lower risk” screen, and pension funds can purchase these bonds because at a lower yield “they’re less risky”, and corporates like Apple can issue bonds to return cash to shareholders, what happens when interest rates rise eventually?

Private sector demand for credit has not recovered from the global financial crisis. We have no way of knowing how dramatic the change in interest rates could be if demand shocks or supply shocks flow through to demand for credit and end up performing what the central banks have failed to do with quantitative easing.

Thus, the search for yield is a double-edged sword that runs the risk of capital writedowns if interest rates rise. If they rise dramatically, or central banks end quantitative easing abruptly, we could find ourselves in another money market liquidity crisis because a lot of borrowing uses bonds as collateral for repo transactions and the like.

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