Low rates lure yield seekers onto thin ice
SOME investors are pursuing the safety of federally insured deposits. Others are dissatisfied with low nominal and negative real returns and are moving further out on the risk spectrum in their zeal for yield, regardless of whether they understand the additional risk they are incurring.
In a speech at Jackson Hole, Wyoming, in late August, Federal Reserve Chairman Ben Bernanke acknowledged this possible consequence of his policies. There are concerns that by pushing longerterm yields lower, the central bank's "nontraditional policies," namely quantitative easing, "could induce an imprudent reach for yield by some investors and thereby threaten financial stability," he said. Yet he dismissed this threat, saying, "We have seen little evidence thus far of unsafe buildup of risk or leverage."
I see lots of potentially unsafe buildups. Consider the rush into junk bonds, depressing their yields and spreads versus Treasuries. So much money has poured into below-investment-grade debt that it now takes real skill to default. In the third quarter, junk-rated companies sold $94 billion in debt compared with $25 billion in the third quarter of 2011. Nonetheless, the global recession will hype defaults even though many low-rated companies have a cushion of safety from prefunded debt.
Zeal for yield has pushed the returns on junk municipal bonds to just 3.15 percentage points more than investment-grade issues, the narrowest gap in two years. These bonds are usually issued by quasigovernmental bodies to finance schools, nursing homes and other facilities. They depend on the revenue generated, and aren't guaranteed by municipal governments.
Master limited partnerships are usually backed by energy pipelines and other investments that produce steady revenue from long-term contracts.
They pay out 90 percent of their earnings, and are able to promote current returns of about 10 percent annually to investors. But in reaction to the zeal for yield, private-equity firms, with the assis- tance of Wall Street banks, are unloading fracking sand, gas stations and coal mines into these limited partnerships and attracting investors with mouthwatering yields.
Northern Tier Energy LP (NTI), which operates a refinery and a chain of gas stations, has enjoyed a 55 percent increase in its share price since its July debut because of a 19 percent yield on the initial-public-offering price.
The share price of Hi- Crush Partners LP (HCLP), which produces sand for fracking hydrocarbons, has jumped 22 percent since its August introduction. It promised an annual yield of 11 percent based on the IPO price. Because of robust investor demand, the market value of master limited partnerships has jumped to more than $350 billion from $65 billion in 2005.
Slightly less risky are commercial mortgage-backed securities, which are in such demand that their yields are at narrower spread compared with their benchmark than when real estate was still booming and risks were ignored. Such securities backed 75 percent of all commercial real-estate lending at the earlier peak, and are gaining in prominence again.
Credit-rating companies, however, are warning that the loan quality of such mortgage-backed paper is weakening, possibly putting investors at risk.
There has also been a stampede into emerging-market bonds and stocks, even though almost all of those economies are driven by exports, the vast majority of which are bought by Europe, now clearly in a recession, and the U.S., which is faltering, too. As early indicators, consider sliding Chinese export growth and the declining Shanghai stock index.
I have long maintained that decoupling ranks with free lunch among things that don't exist. Export-led developing countries simply can't grow independently of Europe and the U.S., which directly and indirectly buy most of their exports.
Recently, the decoupling theory was once again disproved. Just look at how emerging-market stocks, anticipating a global slowdown or recession, have underperformed the Standard & Poor's 500 Index in the past year.
Yet that hasn't slowed yieldhappy investors as they move into the sovereign debt of small countries in eastern Europe and elsewhere. Serbia's 51 percent ratio of debt to gross domestic product is well below those of western Europe and its inflation- adjusted bond yield exceeds 10 percent.
The average debt-to-GDP ratio for the 27-country European Union was 83 percent at the end of the first quarter. Spain's government expects an 85 percent ratio this year and almost 91 percent for 2013. Hungarian bond yields are down from 10 percent last year though they still pay more than 6 percent.