Searching for Yield: At Any Cost?

In an environment with historically low interest rates, fixed income investors have been pouring money into longer-duration securities, substituting 3 and 6 month T-Bills with 10-year Treasures or bond funds. In an environment with historically low interest rates, fixed income investors have been pouring money into longer-duration securities, substituting 3 and 6 month T-Bills with 10-year Treasures or bond funds. To an extent, this should not be so surprising: the Federal Reserve’s (the Fed) extraordinary monetary policies have resulted in extremely low yields at the short end of the yield curve. Investors seeking yield have been forced out the yield curve or into increasingly risky investments in an attempt to gain higher investment returns. However, this is not a strategy without risks, both at the individual investor level and for the economy as a whole. Are the Fed’s monetary policies, combined with the government’s decision to issue increasing levels of longer duration debt, having the unintended consequence of stoking the fire for further financial stress?

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While many observers focus on the increased risks associated with moving into lower quality, higher yielding instruments, and away from the likes of government securities, often overlooked is the increased risk associated with simply moving out along the yield curve. Fixed income investments become evermore risky the further out the yield curve investors move. Moving from the short end of the curve into similar quality fixed income securities at the longer end of the curve may have a marked impact on the overall risk profile of a portfolio, as we will explain in more detail below. Of course, increasing the exposure to lower quality fixed income securities also implicitly raises an investment portfolio’s risk profile, and should be a key consideration before any such decision is made.

Longer duration fixed income securities may have a greater propensity to cause “black swan” type events, given that they historically display fat tail return distributions and much higher levels of price volatility relative to shorter-duration securities. We are most concerned that the aggregate risk profile of many fixed income investments, and especially those underlying future obligations, may have now increased. The implications could be potentially disastrous: the likelihood of another financial catastrophe may have risen; many investments that everyday Americans are relying upon provide future financial security may have been put in jeopardy. Now may be the time for investors to consider fixed income investments at the short-end of the yield curve to take advantage of the diversification benefits fixed income investing may offer, while seeking to mitigate interest risk. Investing outside of the U.S. dollar may also prove beneficial, should present dynamics negatively affect U.S. economic stability.

Recent Treasury data tells an interesting story. Over the 12 months through March 31, 2010, the level of T-Bills held by the public has fallen by 9.4%, whereas Treasury notes and Treasury bonds held by the public have increased by 48.0% and 22.9%, respectively. In just one year, the average length of marketable public debt held by private investors has increased by 7 months: from 3 years, 11 months to 4 years, 6 mont