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Chasing Yield: The Risks Behind the Rush
for Financial Return
Summary:

Attractive, high-yielding products often hide significant risks.

The chase for yield allows financing to leak to borrowers that were previously seen
as being too risky while also allowing borrowers to negotiate more lenient terms
and covenants.

Investors shouldn’t expect to be the first out of the door at any sign of trouble, nor
should they expect manager alpha to prevent capital loss.

Low-risk securities should have an appropriate allocation within investor portfolios,
while higher-yielding assets should be chosen on a selective basis.
Much has been written over the last few years regarding the search for yield by global
investors. Short-term, risk-free rates within the developed world remain at historic lows,
while investors have clamored for securities that provide high immediate income and
the potential to hedge rising rates. This phenomenon ignores the fact that attractive,
high-yielding products often hide significant risks. Even if managers buying these
products have the ability to produce significant alpha, they are still either unable or
unwilling to time the market, while crises often cause widespread selloffs that affect
securities, regardless of fundamental strength. Investors must therefore be aware of the
implications of capital flows within the economy, the conditions in which high yields
could represent excessive risk taking by the market, and identify ways to allocate their
capital that incorporate these risks and avoid overweighting them.
Sources: Bloomberg, S&P 1
EMM White Paper June 2016 – Chasing Yield
The Dangerous Yield-Chasing Cycle
The interminable search for yield is an all too common story. As yields on riskless
securities fall, most investors look to maintain income and return objectives. This
inevitably leads to capital flowing toward riskier, high-yielding assets such as belowinvestment-grade corporate bonds, bank loans, securitized products and niche financing products, causing spreads to tighten. Such an environment also allows financing to
leak to borrowers that were previously seen as being too risky or to sectors of the
economy that are already highly indebted while also allowing borrowers to negotiate
more lenient terms (including greater leverage ratios) and looser covenants. Tighter
spreads and a wider availability of capital driven by a greater supply of buyers, as
opposed to being driven by improving fundamentals, may indicate that investors
receive less return for the risks they take. In other words, the demand for investment
opportunities suppresses the need to understand and limit risk. This behavior sets the
stage for boom and bust cycles.
The Financial Crisis of 2008 illustrated that investors can suffer significant loss of capital
by chasing yield. Mortgage-backed securities (MBS), products holding a collection of
individual mortgages (which were provided to investors in tranches or pieces fitting
different risk profiles), saw their first use in the late 1960s, but they rose to prominence
in the 2000s as interest rates for government paper remained historically low and
investors began searching for sources of incremental return. The mid-2000s saw an
explosion in mortgage credit as investors were attracted to the safer tranches of these
securities. Some investors and institutions began replacing portions of their low-risk
fixed income with MBS, failing to realize that, along with the credit rating agencies, a
significant portion of what looked like safe, highly rated MBS tranches were actually
backed by subprime and highly risky mortgages.1,2 Needless to say, the real estate bubble burst, and investors who had moved capital into MBS and other high yielding securities suffered. Even though risks seemed to be isolated within the real estate sector,
the risk-averse environment in 2008 created a liquidity crisis that swept through much
of the credit spectrum, causing highly negative and disproportionate consequences for
niche and illiquid
high-yield securities
specifically. Even
strong performing
managers who had
historically been
successful within the
levered and hard
asset lending spaces
experienced tremendous capital losses as
macro events caused
indiscriminant selling.
Sources: Bloomberg, S&P 2
EMM White Paper June 2016 – Chasing Yield
Same Script, Different Country
The recent drawdown in Brazilian currency and government debt is another prominent
and recent example of how investors attracted by high-yielding instruments can take on
substantial downside risks. Late 2014 saw the Brazilian Real start a depreciation that left
it at its lowest level versus the US dollar in the last decade. The USD/BRL exchange rate
depreciated by as much as 51% from its 2013 levels in just a few months in 2015 before
rebounding slightly. Likewise, Brazilian local bonds not only depreciated along with the
Real but also lost significant value as investors demanded much higher interest rates to
carry Brazilian debt (rates jumped from around 11-12% in late 2014 to 16% at one point
in late 2015).
Source: Bloomberg Many investors and managers had seen the yield on the Real as an opportunity to
earn carry, even for a limited time, and perhaps exit when the Brazilian economy
deteriorated. This is a classic example of a crisis fueled by a rush to exits with yield
seekers thinking they would be first out the door. It is notoriously hard to time markets,
especially currency markets, and the experience with the Brazilian Real was no different.
Other investors were simply attracted by the yield, in effect, ignoring risks such as
Brazil’s low rates of investment, a decline in global competitiveness, a high rate of
inflation, high interest rates and taxes, a weakening commodity cycle and a slowdown
in Chinese demand.
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EMM White Paper June 2016 – Chasing Yield
Beware the “Free Lunch”
None of this is to say that an investor should avoid high-yielding assets and leverage
altogether. Earning a return above the risk-free rate requires taking some risk. However,
investors should refrain from considering high-yield assets as low-risk simply because
loans are currently performing. A high yield is not a guaranteed return. Investors should
also refrain from adding significant risks to their portfolio simply as a response to yield
compression. Low, risk-free yields are a fact of investing and represent the current
environment in which we live. Regardless of low yields, fixed income still remains one
of the most effective hedges for risk assets in investor portfolios. As the saying goes,
“There’s no such thing as a free lunch,” and the promise of a higher yield with no
additional risk is one of the most dangerous impressions an investor can entertain.
Today, we are reminded of the search and reach for yield in a variety of asset classes.
High-yield spreads have, at times over the current recovery period, traded at close to
historical low spreads to treasuries. There has been a rush to allocate to all types of
lending products including peer-to-peer lending platforms, leasing products, private
company lending, private credit products and structured credit.3 The introduction of
Dodd-Frank legislation as well as stricter regulatory enforcement and low bank
profitability has forced banks to restrict credit to more niche and segmented parts of
the market including the middle market, some consumer lending, the levered loan
market, equipment leasing, etc. Money managers have attempted to fill this gap, seeing
the lack of competition by banks as an opportunity. Many products and managers have
no track record and, in the rush to market, may not have proper procedures and risk
management in place as we just saw with Lending Tree. Opportunity or not, investors
Source: Bloomberg Source: Bloomberg 4
EMM White Paper June 2016 – Chasing Yield
should be wary of changing risk profiles for certain asset classes as they become more
accessible to institutions and the high net worth segment. With the transition of credit
availability from banks to money managers, competition may not be disappearing but
simply migrating to hedge funds and other highly motivated and capable investors
while borrower profiles and lending terms could see deterioration as investors chase
opportunity.
Final Thoughts
In an environment of low, riskless rates like today, we have to remind ourselves not to
reach too far or too high. High yields in this environment of low, risk-free rates often
point to speculative, highly risky assets as opposed to a “free lunch.” Low-risk securities
should have an appropriate allocation within investor portfolios, while higher- yielding
assets should be chosen on a selective basis at the margin after proper due diligence.
Investors should not expect to be the first out of the door at the any sign of trouble, nor
should they expect manager alpha to prevent capital loss. Diversification and risk analysis are crucial to constructing a portfolio that achieves an investor’s goals, and understanding the risks investors take is the first step to achieving that end.
1 Source:
NY Times. http://www.nytimes.com/2010/09/25/business/25nocera.html?_r=0
2 Source:
The Wall Street Journal. http://www.wsj.com/articles/SB118230204193441422
3 Source:
The Wall Street Journal. http://www.wsj.com/articles/loan-valuations-draw-scrutiny-1455237154, http://
www.wsj.com/article_email/SB10001424052748704878904575031640396411182lMyQjAxMTAwMDAwMjEwNDIyWj.html, http://www.wsj.com/articles/clo-debt-market-peps-up-1463960641, http://
www.wsj.com/articles/subprime-flashback-early-defaults-are-a-warning-sign-for-auto-sales-1457862187, http://
www.wsj.com/articles/the-uberization-of-finance-1446835102
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EMM White Paper June 2016 – Chasing Yield
About EMM
In 1968, EMM pioneered highly personalized, proactive wealth management services for
affluent individuals and their families. Now in its fifth decade, the distinguished multifamily office manages approximately $2.3 billion in assets from its offices in New York
City. With a 360-degree approach that integrates best-in-class financial planning, tax
planning and investment management, EMM’s clients include successful entrepreneurs
and leaders in the entertainment, legal and financial fields, as well as families with multi
-generational wealth.
To learn more about how EMM can help preserve, protect and grow your wealth and
well-being, please contact Randy Kaufman at [email protected] or 212-476-5354.
Important Disclosures
EMM prepared this material for informational purposes only. It is not an offer to buy or sell or a solicitation of any offer
to buy or sell any security/ instrument, or to participate in any trading strategy. This material does not constitute financial, investment, tax or legal advice and should not be viewed as advice or recommendations with respect to asset
allocation or any particular investment.
Certain information contained herein concerning economic trends and market performance trends are based on or
derived from information provided by independent third party sources that, in certain cases, may not have been updated through the date of this letter. While such information is believed to be reliable for the purposes used herein, EMM
has not independently verified the assumptions on which such information is based nor assumes any responsibility for
the accuracy or completeness of such information.
Certain information contained in this presentation may constitute “forward-looking statements,” which can be identified
by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,”
“estimate,” “intend,” “continue” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties (including those noted herein and in the offering materials of the applicable), actual events or results may differ materially from those reflected or contemplated in such forward-looking statements and EMM disclaims any and all responsibility and liability in the event any assumptions set forth in such forward
looking statements fail to materialize in part or whole.
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