Photographer: Chris Ratcliffe/Bloomberg

It's Not a Search for Yield but a Scramble for Safety

Low yields have not always meant low returns in recent years.

Some eight years after the financial crisis, investors are still petrified of risk assets.

That statement might not ring true for anyone familiar with the 'reach for yield' that is said to have sent investors scurrying into riskier securities in recent times. But a new note from Bank of America Merrill Lynch turns that narrative on its head arguing that the "search for safety" has trumped the search for yield — at least, in terms of returns.

At issue is the degree to which lower yields on benchmark government debt have actually pushed investors into riskier assets — a key goal of central bank bond-buying programs known as quantitative easing. Faced with lower yields, investors must shift into riskier, higher-yielding assets to generate their required returns, or so the thinking goes.

But charting the returns of bonds and stocks against their respective effective yields as of December 29, 2015 — a recent peak for yields on U.S. Treasury — shows little relationship between the two. Or, as Credit Suisse AG analysts also pointed out last week, some of the lowest-yielding assets have been the best return-generators in more recent years.

"Our skepticism around the 'yield chase' narrative is driven by the dissonance between yields offered by various assets and realized returns since that time," write BofAML strategists led by Rachna Ramachandran. "There is no discernible relationship between yield and return in the chart."

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Source: BofAML

Instead of a search for yield, the BofAML analysts argue, the world has been characterized by a scramble for safety. Those assets perceived as the most secure — such as government bonds — have generally outperformed in recent years even as their yields tumbled ever lower. 

That dynamic effectively means that investors have been reaching for duration — or bonds that are more sensitive to interest-rate movements — in order to make up for a paucity of yield. Faced with a decision between credit risk (the possibility of the issuer defaulting) or duration risk (the possibility that if interest rates go up, the price of the bonds will fall more than other types of debt)  the latter has generally won out.

For instance, bonds sold by U.S. companies with stronger balance sheets yielded 3.7 percent in December of last year, according to the analysts, but returned less than half of the performance of U.S. Treasuries, which yielded a similar 3.04 percent but came with triple the duration.

"Given a choice between extending duration and going down the risk spectrum to avoid negative yields, investors have overwhelmingly chosen the former," they write. "In our view, it is not so much that negative yields are driving investors into riskier assets, more so that they are being forced into a dwindling pool of 'safe assets.'"

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Source: BofAML

The analysis provokes the question of whether there is a tension between unconventional monetary policies aimed at lowering benchmark-bond yields and shifting investors into riskier assets, and post-financial crisis landscape that sees — and in some cases requires — investors to build large war chests of 'safe' securities.

It also sets the stage for a potentially painful tightrope walk by central banks, which are left to tend a potentially explosive powder keg of ever lower interest rates and growing duration risk.

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