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“This is a time to be vigilant”: The need for short-term caution in the search for yield

22 August 2017

Columbia Threadneedle Investments global head of fixed income Jim Cielinski believes the search for yield will run into the long term but argues that the outlook is more complicated over shorter time frames.

By Gary Jackson,

Editor, FE Trustnet

The search for yield is a powerful trend that is likely to run through markets for decades to come but this does not mean investors should lose sight of the fact that several near-term risks can be seen for income-paying assets.

That is the view of Jim Cielinski, global head of fixed income at Columbia Threadneedle Investments, who argues that cyclical risks are growing within bond markets. This mean that investors will likely be forced to discern between a market correction, the end of a credit cycle and the end of the search for yield phenomenon over the short-to-medium term.

“Discussion of the factors that might curtail the demand for yield must distinguish the long-term outlook from the short-term outlook. For those worrying about the long-term sustainability of the search for yield, stop worrying. This trend has staying power,” he said.

“The shorter-term view is more cyclical and warrants more caution. Warning signs are mounting from a variety of credit quality measures, and valuations are challenging. Even with a shorter-term focus, however, we lack clear evidence that near-term risks will overpower the secular wave in 2017.”

Performance of gilts vs stocks over 10yrs

 

Source: FE Analytics

In the years since the global financial crisis, the search for yield has contributed to the strong performance of assets such as government bonds. This has been part of the reason why gilts have been able to match the returns of the FTSE All Share over the past 10 years, as the above chart shows.

However, Cielinski said that those who think the demand for income is solely down to post-crisis factors – such as historically low interest rates and a generally cautious stance from investors – are mistaken. Indeed, he pointed to a number of factors why investors will continue to prioritise income over the decades to come.

These include the likelihood that interest rates will continue to remain very low for some time to come, the move of higher-risk fixed income assets such as high-yield and emerging market bonds into the mainstream, and greater demand for fixed income on the back of ageing demographics.

But this does not mean the global head of fixed income thinks it will all be plain sailing from here.


“Investors will not take comfort from a purely long-term view. Indeed, markets can fall precipitously over short-to-medium time horizons. The mere existence of a strong appetite for income does not imply that income-oriented assets will be reasonably valued. Rather, it is a reminder that valuations are likely to occasionally diverge materially from fair value,” Cielinski (pictured) said.

“Make no mistake about it – the asset classes that provide high levels of income are relatively expensive. Moreover, there are warning signs that the fundamental drivers underpinning these markets are worsening.

“It is important not to grow too short term when speaking of the credit markets. We are not concerned with forecasting a mere correction. Nor do we believe there are timing tools available that are robust enough to do that consistently.

“Any yield-seeking environment will be populated by numerous corrections, some of them material. We are concerned with issues that might impact the broad trends, end the credit cycle or represent a regime shift that would reverse the powerful ‘search for yield’ secular trends.”

Cielinski argued that there are five signals that can act as lead indicators for a major turning point in credit cycles and asset class performance: deteriorating measures of corporate and sovereign health; a less accommodative policy backdrop; a reversal in the macro backdrop/an increase in macro volatility; depressed market volatility; and extreme valuations.

Looking at bond markets today, he added that corporate health appears to be worsening when measured by leverage and interest cover, monetary policy – while providing “extraordinarily low” real rates – is growing less supportive, volatility is at low levels relative to history and valuations are very expensive, but not quite in bubble territory.

“The picture today is a mixed one, but is more worrisome than it has been since the beginning of the recovery in 2009,” he said. “Many of our credit indicators are flashing amber, and some of them red. This is a time to be vigilant.

“Our work on credit cycles has highlighted that the factors that create the end of one credit cycle are often not the catalysts for ending the next one. Are there unique features of the current cycle that might give us clues as to what might disrupt the status-quo? We believe there are. The one shift that would seriously undermine the search for yield trade is macroeconomic volatility.”

Cielinski pointed out that most high yielding areas of the fixed income market do not actually require strong growth to prosper as slow and steady growth is often “the perfect recipe” for their success. What is important, he added, is that macro volatility remains low.

“Rapid growth, particularly when accompanied by higher inflation, is worrisome because of the policy response it induces. Receding growth is also a worry, particularly when growth or inflation is near recessionary levels,” the global head of fixed income said.

“Low volatility is the ingredient that perpetuates and reinforces the search for yield. A sustainable low-yielding, low-growth environment simultaneously alleviates concerns of economic overheating and economic recession.”

One of the defining characteristics of the post-crisis growth trajectory has been its stability, with economic volatility in this cycle being much lower than in the previous one. This has been due in part to global deflationary forces acting as constraints on the upside and policymakers easing downside risk by intervening when conditions look too difficult.


“It does not get much better for driving a drawn-out search for yield. It is difficult to see credit or emerging markets underperform for long if the global economy can remain on this tightrope. For without a collapse in the economy, there will not be a broad-based collapse in cash flow, suppressing default risk,” Cielinski said.

However, he added that “threats to the search for yield in the next two years will stem from threats to this moderate pace of global growth” and warned of three areas that bond investors should watch for trouble.

Firstly, a monetary policy mistake, with overly aggressive tightening from the Fed being the biggest risk here; materially higher real rates, which would have the effect of pushing up defaults; and China, as a badly-managed slowdown will create debt-deflation fears.

“Investors should filter through the noise and maintain their focus on factors that might permanently alter the low-growth, low- inflation dynamic,” Cielinski concluded. “Without a change in those underlying fundamentals, corrections are likely to be just that – corrections.”

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