Quenching the Thirst for Yield

As signs of stability returned to capital markets in recent weeks, we’ve begun to hear investors inquire as to how to improve yield in their cash portfolios. We acknowledge that, first and foremost, the return of risk appetite is a welcome and healthy sign after a period of frozen credits and a crisis of confidence. We caution, however, that the quest for higher yield should not be influenced by the low yield on “risk-less” assets, but by the fundamental improvement in asset classes that carry greater risk. If the decision to improve portfolio yield is not based on sound principals, investors may face the consequences of potential bond yield bear traps or a credit risk whiplash.

Low Yield Is a Reality to Be Reckoned With

The pain felt by cash investors dealing with low returns is real. Recent excessive risk aversion has driven yields on Treasury bills and Treasury money market funds to near zero, and briefly to negative levels. In response to the housing market crisis, the Federal Reserve took the benchmark Federal Funds Rate from 5.25% in September 2007 all the way down to a range between zero and 0.25%. A number of government programs aimed bringing money markets back to normal after the 2008 freeze also resulted in the collapse of LIBOR rates, the global inter-bank lending rates upon which most non-government assets are based. For example, the 3-month LIBOR rate dropped from 4.82% on October 10, 2008 to 0.66% on May 22, 2009, representing a loss of 86% in interest income on a typical loan.
The collapse of yield potential in cash assets is also the result of the market-wide paradigm shift of “deleveraging” and “de-risking.” Financial leverage allowed debt issuers and market intermediaries to enhance investment returns through high levels of borrowing. The burst of the credit bubble forced the reversal of this process. The impact on cash investors is that there are fewer borrowers willing to pay juicy yields as their own return opportunities dwindle due to deleveraging.
Now that the credit crisis has largely run its course, the de-risking process by cash investors is perhaps in full swing. Various proposals to eliminate certain asset classes, limit risk, and constrain ratings requirements only further serve to limit yield potential in cash portfolios. For example, the Investment Company Institute’s Money Market Working Group has proposed a number of ways to limit the risk of money market funds. Such measures include shorter portfolio average maturity, higher allocation of securities to overnight and one-week maturities, and a new requirement of “spread WAM”, which is a measurement of sensitivity to credit risk. The designers of the proposal, who are CEOs of major money fund firms, acknowledged that these changes will result in lower yield potential, all else being equal.
In summary, the confluence of factors that contributed to lower yield in cash portfolios may not dissipate any time soon. Investors should not have unrealistic yield expectations in the near term. Stepping up interest rate risk or stepping down in credit quality to stretch for yield can ultimately have severe adverse effects on portfolio performance.
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