Yield chasing refers to the situation where a central bank is suppressing interest rates at low or negative levels.
Yields in Good Times
When investors buy stock, they hope to make money by selling at a higher price than they paid for those shares, with an additional return component if the securities are dividend-paying stocks.
The dividend (or stock yield) is calculated by dividing the annual total dividends received by the current share price. This metric helps gauge the potential upside or risks of investing in a particular stock.
Bond investors expect to make money from the common interest or coupon payments. Additional returns occur if they purchase the bond at a discount and sell at a premium (to face value) before the maturity date when bondholders get paid the face amount.
The simplest way to calculate a bond yield is to divide the coupon payment by the face value unless the bond was purchased for more than its face value (premium) or less than its face value (discount), which will affect the yield earned investor.
Bond prices and yields move inversely to one another. Fear-based trading in a volatile market environment tends to push yields even lower. Some of the most widely quoted yields are for U.S. government bond issues and the benchmark U.S. 10-year notes, which dropped to a record low of 0.318% towards the onset of the COVID-19 pandemic in March 2020.
Yields in Bad Times
The pandemic hit the global economy before markets could fully recover from the 2008 financial crisis, sparking an unprecedented monetary policy response from central banks worldwide.
While quantitative easing was used in 2008 (and considered unconventional monetary policy even then), the sheer volume of QE used in 2020 pushed bond yields in most developed markets toward zero or, in some places, into negative territory.
With risk-free interest rates at essentially zero, there weren’t a lot of yield morsels to go around. So, to generate income, investors take on more risk or face the possibility of accurate negative rates of return — often referred to as chasing yield.
The Yield Stretch
Investors chase yield when they go further out the risk spectrum in search of decent returns because there isn’t any income to be had with the majority of traditional bonds.
They end up clamoring to get their hands on many large, liquid, highly-rated U.S. bonds regardless of price. But unlike dividends, which can appreciate over time, bond interest payments are fixed for the lifetime of that bond. The higher the price paid to acquire the bond, the lower the eventual overall return.
Let’s compare historical U.S. stock and bond yields to see how much things have changed with the advent of unconventional monetary policy actions and two big market crises in little more than a decade.
The chart above shows an increasing trend as we move towards 2020 when nearly 80% of the constituent stocks that make up the S&P 500 index have a yield above that offered on 10-year Treasuries. It’s a trajectory that started to spike with the onset of the 2008 financial crisis and continued to move higher as the world grappled with the economic devastation wrought by COVID-19.
Stock or dividend yields are expressed as a fraction and fluctuate based on the numerator and the denominator movements. Hence, in late March, the steep drop in stock prices created a sort of “artificial” or a temporary boost to yields.
Subsequent dividend cuts – and there have been many – brought them back down again, though.
COVID-19 significantly accelerated the pace of dividend cuts compared to the financial crisis, while government bonds of just about any term offered paltry yields. In numerous countries, short-term government bonds yields were close enough to zero to call them zero.
This means that for investors to earn any return, they will need to take on more risk than in the past, so they will have to assess their risk tolerance accurately.
The quest for yield is real, but buying a stock or bond simply because it offers a high yield is not a sound investment strategy.
There are other moving parts investors need to consider before putting their hard-earned money into something that might be uncomfortable for them to own long enough to generate a real rate of return.