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09/23/2013

The Yield Famine: Discovering Income Opportunities in a Zero Interest Rate Environment


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OVERVIEW

Fed’s response to the financial crisis created winners and losers. Ultimately it produced a massive transfer of wealth from savers and conservative investors to financial intermediaries, corporations, and risk takers. Retirees and others who traditionally relied on modest and reliable interest received to generate cash income or grow their wealth have suffered an extended period of zero returns while the value of cash is eroded by inflation. Moreover, losses experienced during the crisis removed the risk-taking ability of many investors forced to move to safety.

The “yield famine” represents years of lost returns for savers and investors unwilling or unable to take risk. With the economy still operating below potential, and unemployment being reduced only slowly, short-term interest rates are likely to remain exceedingly low well into the future. Add massive government debt comparable to levels after World War II and “financial repression” is virtually guaranteed for decades. Low rates will continue to keep savers hungry while subsidizing the government, the financial system and the corporations. Meanwhile, profits at the largest US banks are now the highest they have been in history.

Institutions and individuals holding assets in banks and low-yielding funds would be wise to invest directly in the same way that banks do. Cutting out the middleman would provide them with a similar level of safety that banks enjoy, yet generate substantially higher returns. However, doing so requires, first and foremost, the knowledge to find the right opportunities coupled with the courage to move out of the comfort zone and take a modest level of risk. Investors with diversified portfolios across the risk spectrum might also find it rewarding to reallocate both ultra low−risk and very high−risk assets into moderate-risk assets with superior risk-adjusted returns.

The Conference, hosted by NYSSA Private Wealth Management Committee on October 1st, 2013, presents a menu of choices available for generating income from various sources. Topics of presentations include: expanding outside the US into the global bond market, using equities for income and growth, a look at the advantages of preferred stocks, visiting synthetic bonds, evaluating the risks and returns of muni bonds, and sampling Master Limited Partnerships and Business Development Companies.

ZIRP

Federal Reserve and its Chairman are often praised for the swift and forceful response to the financial crisis, which helped avoid a repeat of the Great Depression. Both conventional and unconventional monetary policy actions were used to increase liquidity, shore up the financial system, stimulate the economy, and reduce the high level of unemployment. Reducing the overnight borrowing rates is a standard conventional policy response and the Fed, unlike other central banks, took the bold step of reducing this rate to near zero.

The zero interest rate policy (ZIRP), along with infusions of cash, saved the financial system from imminent collapse in 2008. Since then, “too big to fail” institutions along with their thousands of smaller brethren were able to borrow at infinitesimal rates. Such ample liquidity and low rates propagate through the system, and  determine the rates of all other ultra-safe, short-term lending and borrowing such as Treasury bills and commercial paper. In turn, these rates determine the interest paid on so-called Money Market funds and bank accounts as well as interest on short-term Certificates of Deposit or Bank Savings Accounts.

LONG LASTING

Short-term interest rates are unlikely to rise by any substantial amount in the near future for  a few reasons: continued quantitative easing, massive government debt, and demographics. Quantitative easing (QE) is an extension of the conventional monetary policy using interest rates. Most likely, an increase of the Fed Funds Rate would have to be preceded by the complete stop of Fed’s asset purchases. There should also be a reasonable belief that no further QE would be needed. Since the Fed is just beginning to consider a “taper” from the $85 billion per month in purchases, a lasting and complete QE stop may be a long way off. It is also possible that the Fed may wish to unwind at least a portion of its balance sheet before raising rates. This would push the time to raise rates further into the future.

Government debt has more than doubled since the crisis and now stands at 16.7 trillion or about 100% of GDP. Such high levels of debt-to-GDP have not been seen since the end of the Second World War. Government’s massive borrowing gives it a strong incentive to keep the interest rate it pays as low as possible to avoid piling on even more debt. With most of the government borrowing concentrated in short-term securities, it is in its best interest to have short-term rates close to zero. Fed’s independence would not be a barrier if it acted in the interest of the country and kept rates low. In the 1940’s and 50’s, interest rates well below the rate of inflation amounted to what is now known as Financial Repression. History appears to be repeating.

Lastly, demographic changes in the US, as a result of retiring baby boomers, present serious economic challenges. Lower consumption levels reduce the rate of growth while future promises in entitlements are estimated at a gigantic $200 trillion, according to some . The economy is unlikely to have such hypergrowth to support those levels of spending. Thus, the government debt is likely to start increasing massively by the end of the decade. Larger debt is likely to extend financial repression much further into the future while inflation is likely to rise.

FAMINE

The objective of yield-oriented investors is to generate a steady cash flow from a moderate return with a high degree of safety of the principal capital invested. This applies primarily to retirees who need a relatively fixed income for living expenses. It is well known that a loss of principal account value, especially in the early years of retirement, can have very negative or even devastating consequences in one’s ability to fund future needs. This is because assets get depleted quickly at low valuations and can no longer recover from a low base.

Years of missed returns cause serious setbacks and greatly increase the risk of running out of money during lifetime. Many institutional investors such as endowments, foundations, and pension plans have substantial assets in safe investments. An extended period of near zero returns impairs the ability to meet their objectives and in some cases can even threaten their long-term viability.

Ultra-safe investments caused investors to experience a yield famine. The Great Irish Famine in the mid-nineteenth century caused a massive death toll, disease, and misery because the majority of the population became almost entirely dependent on a single source of food: the Irish Lumper potato. Ironically, even during the famine, the country overall produced enough food to feed its people. Starvation occurred because the food produced within the country did not get to the people,  for various political and economic reasons,. Likewise, there appears to be a sufficient amount of yield in the investment universe today. However, for different reasons, it is not getting to a large category of investors.

FEAST

While depositors are starved for yield, the financial industry continues to feast. Profits at big banks and financial institutions have recovered quickly after the crisis and are making new highs again. This is in spite of the fact that banks are quite inefficient and have high costs. Running a large bank is an expensive operation that includes rents for headquarters and branches, expensive internal systems, regulatory overhead, and large salaries and bonuses paid to senior staff and executives.

Ironically, after having been one of the principal causes of the crisis, the financial sector is now reaping 30% of all domestic corporate profits while contributing only 8% to GDP. As the chart below shows, on a percent of GDP basis, the Financial Profits are at all-time highs. Clearly, financial institutions are having a profit bonanza and getting more than their fair share from the income pie. Largely because of the Fed policy, their profits are subsidized by depositors who lend money at zero interest.

Yield-Famine

Source Atayant Capital

Based on these facts one would deduce that investing in banks should produce outstanding results. Nonetheless, experience shows that stocks of the financial companies have not been on par with the expectations. Why the difference? One explanation is that a large part of the profits since 2007 has gone to fight alleged misbehavior. According to Bloomberg, the six largest banks in the US paid $103 billion in legal costs and settlements with the regulators for selling shoddy mortgages, misleading investors, or manipulating the LIBOR rate. By comparison, their total payout in dividends to shareholders of common and preferred stock amounts to $98.6 billion during the same time.

OPTIMIZING BALANCE SHEETS

Given the dire state of affairs for savers, one would assume that a large part of them would revolt and vote with their feet. However, paradoxically perhaps, the amount of money on deposit with the banks has increased by 70% from $4 trillion to $6.8 trillion between 2008 and 2012. It appears that businesses, institutions, and individuals are making this voluntary decision because they either too scared, don’t fully understand the consequences, are unaware of other choices, or are simply complacent.

Most people automatically associate investing with the stock market. This is an incorrect view since every held asset type and liability (such as mortgage or credit card debt) should be considered. For example cash in a bank account is an investment losing value because of inflation. Business or personal debt is an investment choice that can earn the interest rate currently being paid to the lender. For example, a business paying 7% interest on a loan can “invest” in its own debt by paying it off. Importantly, this is a risk-free rate of return for that business.

Mental accounting biases are likely responsible for viewing investment accounts separately from cash and from debt. Instead of thinking in terms of managing investments, both advisors and investors should be thinking of managing balance sheets.

Typical balance sheets tend to be suboptimal. Investors holding cash and low-yield assets while simultaneously having debt are subsidizing the financial system.  Some low-yield assets may be hidden in the portfolio inside money-market funds or diversified bond funds. Investors may have much higher allocations than they are aware of in such assets. Well-diversified portfolios also tend to have a portion of assets in high-risk investments or strategies. The high-risk part of the portfolio tends to underperform more conservative investments on a risk-adjusted basis. (Reasons for such underperformance can be the object of another analysis.)

Both low-yield allocations and high-risk allocations can generate a serious drag on the balance sheet performance. As a general rule, investors should avoid extremes and reallocate these types of holdings to value investments with moderate risk and positive expected real rates of return. Investors may be surprised to find that the overall risk of their balance sheet may remain nearly the same, while long-term returns could be substantially higher.

Because of the highly profitable nature of the banking business, investors can learn a great deal from the way these financial institutions are managing their own investment portfolios. Moreover, by understanding that the principal role of the Fed is to deal with financial crises and protect the banking system investors can have a higher degree of confidence in their investment strategy of following the model of financial institutions.

Astute investors are able to find opportunities for attractive yield and returns from different sources:

  • Bypassing banks and investing in similar ways by lending to consumers, governments, municipalities, and businesses.
  • Implementing strategies used by financial institutions, including capturing the spread between short term and long term interest rates, insuring risk, purchasing securities at a discount, and capturing premiums for illiquid investments.
  • Lending to banks by investing in the bonds or preferred stock issued by banks and other financial institutions.
  • Identifying investments with solid collateral and attractive cash flows such as commercial properties and master limited partnerships.

The “great rotation” that many speak about does not have to be from fixed income to equities but rather from a yield famine to real return.

–Robert Andriano, CFA is the Chief Investment Officer of Pure Investment Advisers, Inc., a boutique investment management firm specializing in portfolio management and comprehensive balance-sheet optimization. For more information please visit the company website at www.pureinv.com

As an impartial, nonprofit forum for the finance and banking industries NYSSA encourages discussion and debate among its member and other professionals. Commentaries, however, should be taken as the sole opinion of the author(s) and not of NYSSA. If you would like to submit a commentary to the Finance Professional's Post, send your article to the editor.

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