The share-market rally of recent months notwithstanding, investors are still searching for yield. And the more security there is attached to this yield, the better they like it. The memories of the fallout in markets post-global financial crisis are still fresh.
Anyone doubting this proposition should look closely at those stocks that have been driving the domestic share-market rally since the second half of last year. In a nutshell, it has been stocks offering fully franked and attractive yields such as the big four banks and Telstra. Income understandably remains front and centre of most investors’ thinking.
The equities now in demand are one pointer to this quest for yield; another is the anecdotal evidence we accumulate from financial planners who are notably apprehensive about how they can satisfy their clients’ income needs in a low-yield world.
This is particularly pertinent for a bond manager who has to deal with the notion that the debt markets are primarily about government bonds – a widely held misconception.
Opportunities in global debt
What needs to be understood by investors is that the global debt market is worth about US$100 trillion, and that in this market it is possible for an active manager to find attractive yields while still placing a premium on capital preservation.
Examples of such a bond strategy in a diversified portfolio could include:
• Opportunities in emerging markets – The long-term dynamics in emerging economies are favorable due to lower levels of debt compared with the developed world. There are also attractive valuations in emerging-market corporate credits.
• Structured products – Focusing on structured products such as non-government mortgage-backed securities and commercial mortgage-backed securities.
• Floating-rate bank loans – Floating-rate bank loans that banks make to companies, typically at senior positions in the capital structure relative to high-yield corporate bonds. (Companies receiving such loans generally do not qualify as investment grade). While providing attractive return opportunities in an improving economic environment due to the floating-rate coupon (which should be expected to increase along with market rates), these loans may also provide a potential downside hedge in a negative economic environment (potentially resulting in defaults) due to access to collateral and a senior position in the corporate-capital structure.
Chasing higher yield
There is another aspect to this search for yield in Australia. Post-GFC, bank deposits offered investors solid – and secure – returns. Today, they are faced with term-deposit rates plummeting. As a consequence, we are seeing heavy interest in hybrid securities as investors chase higher yield.
But there are risks in pursuing the highest returns without looking at it on a risk-adjusted basis. Investors need to remind themselves of the capital structure and aim to position themselves towards the top of the debt pyramid with high quality asset-backed bonds and senior debt, rather than at the bottom with hybrids.
It’s a bit like a building in a flood – the bottom floors get wiped out while the higher levels stay dry.
Peter Dorrian is head of Global Wealth Management at PIMCO Australia
