The search for yield

Investors want yield. Many will take on quite a degree of risk to earn it. But yield has become difficult to find over the last five to eight years and there is every prospect that it will remain elusive for the foreseeable future. Are we mired in a never-ending low yield out-look?

To a large extent, the low yield environment has been deliberately generated by central bank policy in most countries. Faced with the prospect of a recession after the the sub-prime financial crisis, including the collapse of some banks, US and UK central bank policy engineered a reduction in interest rates by creating cheap easy money (in effect, printing banknotes) as a matter of priority. On top of that, fiscal expenditure programmes were instituted in haste, a course of action followed in Australia to the ludicrous extent of the Government mailing $900 cheques to citizens (including dead ones, of course). The end result has been budget deterioration, increased public debt and, crucially, a distortion in the structure of interest rates in the market and the delay in cleaning out bad investment projects.

When interest rates are artificially low, the internal rate of return of any given proposed investment looks relatively better than when interest rates are at their natural level. The quality of investment projects hence deteriorates. Poor investments are held onto for longer, rather than cutting losses and redeploying the capital to more useful projects. You see an example of this when advocates for projects such as a very fast train on the eastern seaboard of Australia say “we’d be mad not to build it now while interest rates are so low.” Such projects do not stack up under ordinary circumstances.

So Government-body manipulated low interest rates not only drive down the yield that savers would otherwise earn, they distort capital allocation and inhibit capital being directed to its most valuable uses.

There seems little prospect of a return to normal interest rates any time soon, with the central bank hinting strongly recently that more cuts to interest rates are likely. If the bank does do that, it will be making things worse, not better, as I explained above.

For the investor, this means that debt securities are very unattractive. Bond yields of around 3%pa, bank deposit rates of less than 2%, debentures might get 3-4%. The retirees, the elderly and the pensioners traditionally have looked to debt securities for perceived less risk. It is tough to be in this part of society when yields are so miserly.

The investor therefore needs to look for equity holdings to generate yield. Clearly, this will bring greater investment risk in terms of security of capital. However, the humble bank deposit also has risk in terms of negative real yields. Equity holdings as a class give the opportunity to share in corporate earnings. Dividends and share price appreciation both become potential sources of return. But the equity market as a class is no longer a on a rising tide. Business disruption is going through an accelerated phase as technology changes occur. I won’t say the disruption is unprecedented, but it is certainly more rapid than it has been for many decades. This creates failures and success stories. The successful investor will need to be able to select the successes and avoid the failures. The top 50 companies in the market are a reasonably good source of reliable dividend income. But it is in the small caps that the opportunity really exists. Stock selection rather than sector selection is the key.