Investors the world over are starved for yield. Investments that provide a consistent stream of cash flow are vital for insurance companies, pensions, retired individuals and banks. This category of investors often has only a limited ability to invest in equities based upon risk tolerance driven by the need for consistent cash flow to fund current cash needs. Historically, the bond market has been the capital markets’ segment to which such investors have turned to meet their investment objectives.
In the aftermath of the global financial crisis, central banks enacted policies to drive interest rates lower in order to stimulate the global economy. As such, both the Federal Reserve and the European Central Bank bought bonds to push down interest rates. These policies were quite effective and interest rates remain low today. Interestingly, demographically speaking, the developed world's population is aging rapidly and the fertility rate in the developed world has declined below the replacement rate. New household formation for younger people is a significant demand driver. All of this to say that lower population growth leads to slower aggregate economic growth, lower inflation and lower interest rates.
Though down from the 2016 peak of $13 trillion, currently, there are $11 trillion of negative yielding government bonds in the world. With negative yielding bonds investors are essentially paying governments for the privilege of owning their debt. On the surface this makes no sense; however, many categories of investors are required to own certain types of government bonds. For example, German banks are required to own debt issued by the German government as reserves … which helps explain why German 10-year bunds currently yield a negative .20 percent.
Given this backdrop, investors have increasingly turned to the riskier corners of the fixed income market and investments outside of the bond market to find yield. Investing in bonds that are not issued by governments can provide more yield to compensate for the possibility of credit risk. With credit risk, the jeopardy is that investors will not get paid back their principal investment and interest. Theoretically, the greater the potential incremental return, the greater the possibility of a credit loss. In addition, investors are increasingly allocating capital to commercial real estate and real asset investments to get predictable cash flow. Examples of real assets are timber investments or infrastructure assets that provide current income.
Low interest rates are both a positive and negative in the investing world. For corporate borrowers, low interest rates stimulate growth by lowering the overall cost of capital. For governments, lower interest costs enable the public sector to provide greater services to citizens at a lower cost. However, as an investor looking for consistent cash flow it has presented a great challenge. At Ferguson Wellman, many of the clients we have the privilege of serving fall into the category of investors that require yield to meet their objectives. Stretching for yield is a common pitfall for investors and we carefully consider the risk and reward of investments while focused on generating yield.
Week in Review and Our Takeaways:
For the week, the S&P 500 returned nearly 2 percent, bringing the 2019 return to more than 15 percent. The closely watched employment report for March saw an increase of 196,000 (which was ahead of expectations), wage growth remained moderate at 3.2 percent and the unemployment rate stayed at 3.8 percent.
1 Wall Street Journal