Yield chasing refers to the situation where a central bank is suppressing interest rates at low or negative levels.
The current monetary policy of the central bank is usually running a zero interest rate policy (“ZIRP“) or a negative interest rate policy (“NIRP“).
Due to the ZIRP or NIRP environment, returns from government fixed-income securities are too low, so investors seek higher returns and “chase yield” in other much risker financial assets.
In more sophisticated language, behavioral finance theorists find that if you give us a choice between certain loss and a bad bet, we will almost all opt for the bad bet.
They don’t go one step further and explain that we don’t like to admit to taking a bad bet so we become highly receptive to dubious narratives which seem to turn the fundamentally bad bet into a good one.
The yield chasers who buy risky bonds to get additional yield over negative or low rates on safe bonds spin a narrative according to which the credit risk is actually lower than usual.
For example in the oil industry, they may have subscribed to the speculative hypothesis that oil prices would remain permanently high.
If they boost returns by taking on exchange risk, they tell themselves currency exchange rate fluctuations will remain unusually subdued.
In the equity and real estate markets we have heard much about “there is nowhere else to go,” or “TINA” but in rational mode, the individual would know that prices already reflect the desperation of investors struck by interest income famine.
This is where financial engineers come in.
The job of a financial engineer is to work on the capital structure of firms in ways to bolster apparent rates of return in a rising equity market.
In such famine conditions, financial engineers find that the demand for their services booms.
The main technique they apply is to ramp up leverage, camouflaging this as much as possible (income famine investors are unusually susceptible).
The consequence is the growing financial vulnerability that accompanies the accumulating malinvestment.
Even the yield chasers at the back of their minds fear a bust but they convince themselves that this cannot happen in the short run.
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