Chasing higher yields forces investors to assume more risk

After the 2008 global financial crisis, monetary policymakers across the globe reduced interest rates to buffer their economies. Alongside declining cash rates, US bond yields have also been in a steady decline for the past four decades. This made the phrase “search for yield” popular among international investors, who had to scramble to find respectable income yields from developed market issuers. Emerging market instruments were never really in contention because they fell prey to pressure from risk-off environments and a stronger dollar.

SA, for example, offers relatively strong bond yields but risk appetite is so severely constrained that investors often fall back on their staple diet of US bonds — of which the 10-year yields are below 1%, a fraction of what is on offer in many emerging markets.

Meanwhile, SA investors have become accustomed to relatively higher interest rates. As such, we were largely unaffected by the “search for yield” movement until the Covid-19 pandemic introduced a heavy cycle of interest rate cuts. Now domestic investors have started to flock to other assets to replace yield.

Our bond market is offering attractive yields in relation to recent history, and corporate credit has been a market darling in recent years. Flows to money market funds have remained buoyant as investors de-risk their portfolios.

However, other interest-bearing funds have been experiencing phenomenal investment flows — which are now benefiting from the juncture of a lower risk appetite environment and lower prevailing cash rates.

Though this behaviour is perfectly rational in a certain sense, what is concerning is that investors often take on additional default or term risk to obtain these higher yields. Investors need to understand that generating yield in cash instruments compared with more flexible instruments, such as bonds or credit, hold materially different risks.

From a wealth preservation perspective, you can understand why cash may lose its shine. But in an environment where economic growth is under pressure, the ability of an issuer to pay debts can be severely compromised: the associated risks should always be factored into a decision.

Also bear in mind that historic yields belong to a world that no longer exists. No matter how attractive those yields may have been, if interest rates or the economic backdrop changes for whatever reason, you should adjust yield expectations and re-evaluate the risks associated with those yields.

Allocating money to funds based on their historic yields is a severely flawed approach in the current environment. You are much better off using a portfolio that is sufficiently diversified across a range of asset classes, and which has demonstrated a history of outperformance over meaningful periods. It is far better to rely on evidence of sustainable skill than to chase historic yields.

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PSG Multi-Management (Pty) Ltd FSP 44306.