Investment Outlook: Third Quarter 2021 - The Search for Yield Can be a Dangerous Game
In a perfectly efficient market, the only way to reap larger returns is to take on larger amounts of risk. In reality, no investable market is perfectly efficient, but the relationship between risk and return is still an important tenet of investing.
Interest rates have been falling for the last 40, the decline in rates has caused many conservative investors to purchase higher-risk investments. This trend is most pronounced in bond investing. Take, for example, an investor who only wants to buy treasury bonds because they are deemed risk-free. When this investor purchased $1 million in treasury bonds in the early 1980’s they could earn well over $100,000 per year in interest. Fast forward to today, when that same investor wants to buy $1 million in treasury bonds, they would only earn about $15,000 per year. This change didn’t happen overnight, rates have been trending downward over the last few decades. This trend leaves the conservative investor with a dilemma, especially if they rely on that income to live.
Many investors make up for this income shortfall by purchasing riskier assets that offer a higher yield than more conservative investments. There are several new risks investors might be exposed to, the biggest being interest rate risk and default risk.
Interest rate risk increases as investors buy longer-dated bonds or bonds that mature further from today than a typical bond. Imagine an investor bought two bonds, one that matures in one year and another that matures in ten years, and the following day interest rates moved higher. The value of the ten-year bond would decline by significantly more than the one-year bond. It’s for this reason that in a normal interest rate environment longer-dated bonds tend to offer a higher yield than those that mature more quickly.
Another way investors can look to increase their bond yields is to buy bonds that have a greater chance of default. A treasury bond is considered riskless because the federal government can always print enough dollars to make good on their debts, and no other entity in this country has the power to print money. Since a corporation can’t create dollars out of thin air, investors are compensated at a higher level for loaning them money. The more risk there is a company or municipality can’t satisfy its debt payments, the more the company or municipality must offer in terms of interest payments.
Taking additional risk in an attempt to increase returns over time is not, by itself, a bad thing. Taking additional risks unknowingly or naively is a bad thing. All investments have unique qualities that need to be evaluated before jumping in. It’s important to consider the potential risks of any investment and it’s also critical to consider more than just the income being produced.