The Short View

June 26, 2014 7:32 pm

The difficulties of reaching for income in a low-yield world

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It is rare for such broad-based returns to continue

Falling prices are rarely something investors look forward to. Now they will bring something almost as galling as a big portfolio loss: smug central bankers. Mark Carney, governor of the Bank of England, promised yesterday not to say “I told you so” when prices plunge, but it is hard to believe he won’t at least sport a self-satisfied grin.

Mr Carney is worried about the reach for yield by investors struggling to find income in a low-yield world.

There are still few signs of pre-2007 style financial leverage, with banks significantly less geared (although leveraged equity buying has picked up a lot). Instead of borrowing to boost returns on assets viewed – wrongly, as it turned out – as safe, investors are choosing to buy riskier assets.

The BoE highlights the rush for junk bonds and complex contingent convertible bank bonds (cocos), along with investor willingness to lend to companies on easier terms, particularly in the US.

Junk bond yields are at record lows. Bulls point to the spread over government bonds, which remains higher than in the spring of 2007, even though it is the lowest since the late summer of that year. Buyers should be more cautious: the market is far less liquid than it was then as banks have pulled back, which will make it far harder to sell if predictions of low default rates turn out to be too optimistic.

Buyers of cocos look even more complacent. The bonds convert into equity, or sometimes simply evaporate, if the bank which issued them runs into trouble. According to a Credit Suisse index of the bonds – the terms of which vary wildly – spreads closely tracked junk bonds until last summer. Since then they have fallen even faster than junk as demand picked up. Yet, cocos have never been tested in a crisis. Rather like the catastrophe bonds issued by reinsurers, buyers are focused on the yield, not the hard-to-quantify danger of loss.

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