The Scramble For Yield

iShares’ benchmark Europe-listed corporate bond ETFs, the iShares Markit iBoxx euro (IBCX), dollar (LQDE) and sterling (SLXX) funds, have shown a dramatic turnaround in performance since the depths of the late 2008/early 2009 market collapse.

The chart below shows the total return NAVs for all three funds (i.e., with income reinvested) since the end of 2007, all rebased to 100 at that date.

Although SLXX is trading slightly below its recent highs, IBCX and LQDE have just pushed on to new record prices. Investors are responding to the prospect of a lengthy period of near-zero interest rates in the major economies and are searching for any means of maintaining their purchasing power.

It’s worth remembering that LQD, the US version of LQDE, famously traded at a 10%-plus discount to net asset value during the autumn of 2008, as we covered on at the time. The arbitrage mechanism that’s supposed to keep ETFs’ prices in line with the value of their underlying holdings broke down as the corporate bond market became illiquid and investors sought to get out at any cost.

Now, seven quarters later, we have the exact opposite in terms of investor sentiment and demand. Steady buying of these funds has pushed redemption yields down to 2.83% for IBCX, 4.6% for LQDE and 5.7% for SLXX. These yield levels have nearly halved since the peak of the crisis: SLXX hit a gross redemption yield of 9.8% in March last year, for example.

The yield premium offered by SLXX and LQDE, when compared to IBCX, reflects two things: the higher prevailing yield in the sterling bond market, as far as SLXX is concerned; and the greater duration of the corporate bond exposure in SLXX (8.4 years) and LQDE (7.3 years) when compared to IBCX (3.7 years), resulting in an income pick-up for the first two funds in an environment where the yield curve slopes upwards over time. All three funds, however, have a significant, near-50% aggregate weighting in financials, so their dominant sector and its attendant risks are largely the same.

Remembering Jim Rogers’ investment mantra to “buy panic and sell hysteria”, it’s clear (with the luxury of hindsight) that those brave enough to purchase these funds in late 2008 and early 2009 have been richly rewarded. Are we, however, close to the point where investors’ rush for yield means it’s time to sell?

That’s a billion dollar question, of course. I’m inclined towards the deflation camp, and can see interest rates staying low for much longer. That in itself means that there will be demand for higher-yielding investments.

On the other hand, I remember a second, often-quoted dictum – beware of chasing yield. It was, after all, blind and unquestioning demand for packaged and apparently low-risk fixed income products offering an extra percent or two in income that led us to the credit crunch in the first place.

And at the back of my mind are Andrew Smithers’ recent comments to the effect that, by underwriting private sector default risk, governments have made corporate debt a contingent liability of the state. This has happened explicitly for bank bonds but implicitly too for other sectors. However, argues Smithers, with governments running up against limits in their own debt financing, the value of the state guarantee may be being eroded. Expect default rates to rise as a result, he concludes.

We may not yet be at the end of the remarkable rally in corporate bonds that we’ve seen over the past year and a half. But the recent scramble for yield goes hand in hand with a risk of future capital losses. Perhaps it’s time to take some money off the table.

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