Evidently, investors have a fever, and the only prescription is more yield.[i] At least, that’s the media meme these days. With US Treasurys paying a pittance, income-loving investors have allegedly scrounged high and low for yield, snapping it up wherever they can find it. REITs! MLPs! Utilities stocks! Eurozone bonds! Junk bonds! And in their frenzy, they’ve bid prices far higher than they should be, creating a big fat bubble in pretty much everything and setting these markets up for a nasty fall once the Fed tightens. It’s all quite overstated, in our view, and the thesis has more than a few holes and logical flaws—and, as ever, if everyone thinks something is a bubble, it likely isn’t.
For one, there are some faulty assumptions about investor behavior. No doubt, there are folks who invest for yield alone, and it’s a fair bet at least some are dyed-in-the-wool heat-chasers. But it’s a hop, skip and a jump beyond a stretch to assume every fixed-income investor fits this mold. A lot of bond owners simply want lower short-term volatility and don’t mind the lower long-term return that comes with it. To assume they’d suddenly ditch their long-term goals and go hog-wild for junk, REITs, MLPs and Greece is a touch bizarre. Maybe some did, but not all. After all, someone is still bidding Treasurys higher (and no, it’s not just the Fed).
A lot of the chatter, at least as it pertains to REITs, MLPs and Utilities, centers on recent performance—all have outperformed stocks year-to-date, while Treasury yields have fallen. But there isn’t much evidence this is anything but a coincidence or a side effect of this year’s unexpectedly falling interest rates for categories of stocks that tend toward higher leverage. If there were a strong relationship—if the bubble bravado were true—all would have gone through the roof for this entire bull market, as Treasurys have hovered near generational lows since it began. Not so! REITs and MLPs have outperformed, but until this year began, Utilities were way behind the S&P 500. Not much evidence investors have been hot for their much-ballyhooed dividends. And our guess is their returns this year have a teensy bit more to do with that 22.2% y/y Q1 earnings jump as these firms reaped the rewards of the Polar Vortex.
It also seems a mistake to assume yield alone is driving heat in REITs and MLPs. Yah, REITs’ high yields are attractive, but so, we imagine, was the prospect of a post-2008 bounce-back—REITS were hammered hard after the housing bubble burst, falling nearly 75% from their 2/7/2007 peak through their 3/6/2009 low.[ii] As for MLPs, they’re usually linked to Energy exploration, production and infrastructure projects and are thus widely seen as a way to capitalize on the shale boom. Now, whether they’re the best way is a matter of debate (we’d argue just overweighting the US does the trick), but that’s the perception, and it’s a driver of performance. If there is some euphoria (and overly high expectations) there, it isn’t exactly a market-wide phenomenon. These categories (and sub-categories, if not sub-sub-categories, in MLPs’ case) are extremely small relative to the broader market.
Most concerns, however, center on bond markets—particularly, peripheral eurozone debt and US high-yield corporate bonds, better-known as junk. Yields in these categories are the lowest in ages right now, and investors can’t quite believe reality warrants this. After all, the eurozone periphery is only just out of a debt crisis, and junk is, well, junk.
But those perspectives are out of step with reality. Let’s start with Europe. Yields in Portugal, Italy, Ireland, Greece and Spain are all below pre-crisis levels, and they’ve fallen fast. But in our view, a lot of that movement stems from the fact those yield spikes reflected fears of the eurozone’s disorderly collapse—something investors have long-since realized won’t happen. Not with the European Commission, ECB, national leaders and Parliament dead-set on backstopping the currency and preserving the union. That, plus improved national finances and a free put option from the ECB in Ireland, Greece and Portugal, have helped restore confidence, which seems fairly rational. This isn’t 2011.
As for high-yield corporates, it’s a matter of perception and scale. Despite the moniker and the assumption of our esteemed credit ratings firms, a lot of these companies aren’t actual junk. Many are the smaller, newer firms that couldn’t borrow much from banks while the yield curve was so flat—they turned to capital markets instead. That’s sort of how this is supposed to work.
This doesn’t mean investors are ignoring risk. We can see this in the spreads between high-yield corporates and US Treasurys. That’s what industry folk call the “risk premium”—the extra amount investors demand for the extra risk compared to Treasurys. These spreads are well within historic norms—a bit below the averages from 1995-1998 and 2003-mid 2007. They’ve narrowed quite a bit over the last couple years, but that’s just what happens when the economy improves and default risk falls. The lower the risk of default, the less extra compensation investors require.
And that’s the kicker here. If firms’ balance sheets were a mess, then yah, concern would be quite rational. But balance sheets today are extremely healthy, flush with cash and other liquid assets. Overall and on average, there isn’t much risk of that changing while we’re in an expanding economy. Credit quality is simply higher than all the bubble alerts would lead you to believe.
Now, that’s not to say none of these assets see some pressure when interest rates rise. They might! But again, that’s normal (and it doesn’t mean they fall through the floor, taking the broad market with them). It’s called volatility, and it’s a fact of life in investing. That investors largely don’t see this—and seem to perpetually fear markets are on the brink of some sort of crisis—is a pretty bullish sign of sentiment.
[i] Admit it. You were totally thinking “cowbell.”
[ii] FactSet, as of 7/10/2014. S&P 500 US REIT Total Return Index, 2/7/2007-3/6/2009.