After Fed Chairman Jerome Powell’s dovish statement before Congress Wednesday morning, stocks rose slightly and US government bond yields excepting the 30-year maturity fell. Riskless US Treasury bills have paid more than 2-year or 10-year notes since last May, and the gap between the 3-month and 2-year maturity now stands at about 30 basis points. This isn’t necessarily a recession indicator; it expresses the expectation of investors that a timid Fed might undertake “insurance cuts” in interest rates in response to economic weakness.
The Fed has been so eager to support the price of risk assets that the whole universe of fixed-income instruments is stupid-rich. Investors typically take duration risk (the risk that rising interest rates in the future will reduce the price of the bonds they buy today) in return for more yield. It’s unusual for investors to accept less yield while taking on more risk.
Negative interest rates for most of the government bond universe in Europe have led to even greater distortions. Some junk bonds (corporate bonds rated below investment grade) now trade with negative yields in Europe.
With cash paying more than US government bonds, investors have bought whatever they can find with yield. Leveraged loans, the asset class flagged by bank regulators as a potential source of toxicity in the financial system, have been a favorite source of yield during the past two years. Individual investors can buy leveraged loans through an ETF, ticker BKLN. It offers a yield of 5.22% for a portfolio of loans from companies whose net debt often exceeds six times pre-tax revenues.
A rough gauge of risk is the ratio of expected return to volatility, named after Nobel Prize winner William Sharpe. The one-year volatility of the BKLN ETF is 4%, and the implied volatility built into prices of options on BKLN is 6%. If we take the lower, historical volatility measure, it means that there is a roughly 40% chance of a 4% change in the price of the security – that is, a 40% chance that investors will lose 4% in principal while earning 5.22% in interest. Investors call that picking up pennies on an active volcano.
It’s notable that emerging markets don’t do any better. Global yields have fallen with European and US yields. A portfolio of local-currency emerging market government debt optimized for the best risk-reward might look like this:
I optimized the portfolio to obtain the highest yield for the least volatility (allowing the computer to pick bonds both for yield and diversification value). Virtually all of the portfolio is allocated to Asian bonds: Philippines, Malaysia, India and Indonesia. The portfolio holds trace amounts of Mexico, Russia, Turkey and Brazil.
The risk in the portfolio comes from the possibility that the currency of denomination might be devalued. Portfolio risk is calculated as the volatility of the currency basket of the portfolio in terms of the US dollar.
The best combination of risk and reward that the computer can generate is a yield of 5.4% and a volatility of 3.84% (one-year historical), that is, a Sharpe ratio of 1.4%. That’s more or less identical to the Sharpe ratio of the leveraged loan ETF.
So, pick your poison – default risk in the paper of highly leveraged companies or emerging market currency risk – and the risk-reward ratio is equally unappetizing. There’s no reason to buy longer-term US notes and bonds when they yield less than cash, and no reason to take a substantial risk to principle to add a couple of percentage points to the yield on cash.