Global central banks have reinforced market expectations that interest rates will stay lower longer than previously anticipated. The US Federal Reserve has indicated a conditional commitment to keep the fed funds target at 0.25% at least through late 2014, and each of the US Fed, the ECB, the UK MPC, and the Bank of Japan have engaged in unconventional policy stimulus through government debt purchases to bring down long-term yields. This environment of zero interest rate policy (or ZIRP) creates incentives that could lead to significant vulnerabilities. Institutional investors that hold long-duration liabilities, such as insurance companies and pension funds, are facing balance sheet pressures due to higher actuarial value of liabilities and lower returns on assets. These institutions are pushing their traditional boundaries of risk in search of higher returns, which may include taking on duration mismatches and investing in strategies for which they do not fully appreciate all of the associated risks. This can lead to a vicious cycle since the drive for yield is more intense for investors facing weakening balance sheets.
Household balance sheets in the U.S. are still under repair after the destruction wrought by the collapse of the housing market. Disposable income has also remained sluggish, taking the savings rate down with it. In a ZIRP world, households are forced to reach for yield and speculative gains in more aggressive assets.
Extended periods of low interest rates not only create vulnerabilities in the balance sheets of investors, but breeds new products and mutations of old ones with seemingly prudent investment strategies that involve hidden risks. The high yield and leveraged loan markets for instance, which have traditionally been suitable for sophisticated investors with a penchant for analyzing and evaluating discrete credit risks, have suddenly become retail darlings. Year-to-date inflows into high yield bond funds are over $27 Billion, versus approximately $15.5 Billion for all of 2011, mostly driven by retail funds. The CSFB High Yield Index is up 8.7% already this year, despite several technical and fundamental indicators showing the rally is overextended and overbought. Risk premiums have also shrunk in primary markets where deals are oversubscribed and investors are fighting for basis points rather than percentage points.
A plethora of other alien products are invading investment portfolios. Google, for instance, is using a large part of its $50 Billion cash hoard to invest in automobile loans from Honda and Hyundai, a marked departure from the company’s historical investments in corporate bonds and U.S. Treasuries. Goldman Sachs is packaging up royalty income from music by Bob Dylan, Neil Diamond, Rush, and Cassandra Wilson into five-year bonds yielding 5.25%. Waypoint Homes is purchasing foreclosed homes and converting the rental income into securities for investors that can yield 6% or more. ZIRP has created an illusory market for these products and leading investors to underestimate their inherent risks.
Private credit and direct lending strategies have also seen a boom in asset inflows. We know that loans contain idiosyncratic risks because each loan is unique for a specified purpose and period in time, and needs to be evaluated and structured individually. Direct lending is also dependent on deal access and origination, making the strategy capacity constrained and more illiquid than their traditional asset counterparts such as high yield and leveraged loans. The disparity in private credit returns is dramatic, accentuating the large difference in skill among managers and the importance of manager selection. Many of the new direct lending funds being launched are from former investment bankers with little or no experience in credit analysis, structuring, and collection. In other cases, direct lending managers are coining fancy terms such as “senior second lien loans” that give the specious appearance of safety. ZIRP is the culprit behind the resurging interest in private credit, and sadly most investors in this strategy will face lower than expected returns and higher than expected risks.
Investors need to avoid complacency about persistently low interest rates, and resist investing in high yielding products and strategies without carefully understanding the risks. Investors are understandably exhausted by directionless markets and low yields, but their desire to expand exposure into high yielding strategies should be focused on observable measures (such as proven manager experience and process), not on some faith in unknown aliens.