Plunging yields on fixed-income debt are forcing some investors to “reach well beyond their normal investment ‘comfort zone,’” by taking on more credit risk or buying longer-duration debt, according to Wells Fargo & Co.
“Ultra-low yields can become very counterproductive if generally risk averse investors are forced to take on a lot more risk than they normally do, just to get enough yield to ‘make ends meet,’” Richard Gordon, managing director and fixed-income market strategist at Wells Fargo wrote in an Aug. 24 report titled “The Doubled Edged Sword of Ultra-Low Yields.”
Investors have flocked to bonds amid a slowing economy and reduced expectations for inflation, sending yields on two-year U.S. government debt to record lows and corporate bond prices to the highest in more than seven years. The 10 lowest-yielding U.S. corporate new issues in history were sold in the past 14 months, Deutsche Bank strategists led by Jim Reid in London wrote in an Aug 4 note.
“The government has been very, very successful throughout its various measures in bringing down the cost of credit,” Gordon said in a telephone interview today. These actions to jump-start the economy also have downsides for investors, he said.
“In many cases, yields just do not meet their required hurdle rates,” Gordon, in Charlotte, North Carolina, wrote of investors. While some are buying Treasuries and waiting for a better time to invest elsewhere, others are “reaching well beyond their normal investment ‘comfort zone,’ moving down the credit curve or taking on more duration risk than usual,” he wrote.
Money market rates and certificate of deposits yielding less than 0.5 percent are also forcing retail investors “to make a similar trade-off,” sending them into long-duration bond funds, and high-risk, high-yield bond and leveraged loan mutual funds, he said.
“This is the dynamic that some government officials and lawmakers do not seem to understand all that well,” Gordon wrote.
While further Federal Reserve efforts to purchase assets like Treasuries to increase the money supply and ease credit, may result in temporary economic growth, it will “undoubtedly result in both institutional and retail investors ‘reaching’ a lot more than they should, and systemic risk again increasing as a result,” he said.
The 2-year note yield slid 1 basis point to 0.49 percent today after reaching a record low 0.4542 percent yesterday. The yield on the 10-year note fell to the lowest level in 19 months today as new home sales unexpectedly dropped in July to a record low and orders for durable goods rose less than economists forecast.
The average price of investment-grade corporate bonds is more than 112 cents on the dollar, the highest since July 2, 2003, according to the Bank of America Merrill Lynch U.S. Corporate Master Index.