Yves Kuhn, chief investment officer of Banque Internationale à Luxembourg, explains how investors should approach the issue of finding yield in a world of ultra-low interest rates.

In today’s environment of ultra-low, or even negative, real interest rates, the search for yield has meant moving up the risk spectrum. Given that wealth management is, or ought to be, around preserving wealth as a bare minimum requirement, this situation presents all kinds of challenges. In the following article, Yves Kuhn, chief investment officer of Banque Internationale à Luxembourg, explains how investors should approach this issue. As always, this publication welcomes readers to respond with their views.

Yield has been scarce for some time, but it is even harder to find since the European Central Bank reduced deposit rates to -10 basis points in the summer, and nominal German 5-year yields are only just positive. It is all too easy for private investors to remember the nominal yields of the past, without adjusting those yields for inflation. Even if inflation is low, real yields are often even lower.

Many private investors have not been able to reduce their income expectations in line with falling yields, as they need to maintain their standard of living. Markets are calling for a change in investor behaviour. The traditional buy-and-hold investment strategy is undermined by the fact that bonds trade significantly above par and the yield-to-maturity is very low. In this environment bonds need to be sold and bought and a more active management approach is key to ensuring a return.

What are the risks to consider bearing in mind?

The move towards lower-rated investments implicitly represents a move towards acceptance of higher credit risk. More and more investors are chasing yield, and their strategy in doing so is to switch their investments for ones with higher credit risk than they would have held in their portfolios a few years ago.

Nominal returns on short-dated fixed income investments are increasingly less positive in core European markets, prompting private investors to move out on the yield curve. Investors are willing to accept longer duration, increasing risk.

Take, for example, the effect of an annual 100 basis-point rate increase. In a 5-year paper, this might result in a price decrease of around 4.6 per cent (depending on the coupons). The same increase on a 10-year paper could result in a price decrease of over 9 per cent. One caveat to this is that if the investments are kept to maturity, this volatility is less relevant.

How low to go? The duration investors need to consider will depend on a number of factors. In Europe, only high yield bonds provide a real yield of more than 2.5 per cent within the non-financial sector. A BB+ bond with a maturity of eight years provides a nominal yield of 2.93 per cent (2.53 per cent in real yield terms). Shorter-dated investment grade bonds offer negative real yields (lower than 0.4 per cent). In the US, only high yield bonds and a maturity of longer than 15 years for the investment grade segment provide a real yield exceeding 2.5 per cent. For investment grade bonds with maturities of one to five years, the real yield is negative (lower than 2.0 per cent).

There is also liquidity risk. Investments that are less liquid, blocked from daily or monthly trading, will provide investors with higher yields. Property investments as buy-to-rent opportunities are a consideration in this category. Another element for investors to consider with an investment in bricks and mortar is that despite the assets physical characteristics have of being resistant, they might be less resistant in an economic downfall.

Some countries will offer higher nominal returns, of which Turkey was a typical example in the past. This is linked to the credit risk, but there is also macro and currency component which should not be ignored, but which many private investors struggle to assess.

In the absence of returns from plain vanilla fixed income investments, many private investors will look to move into more volatile asset classes, such as high dividend equities. Investors who are willing to venture into the “low-to-moderate” risk assets can find substantially better returns than those offered in the “safe” category.

Investors looking to improve yields need to adjust their financial behaviour. To limit risks, investors should diversify investments among various asset classes and currencies, analyse their cash needs and the capacity of the market to deliver returns, and also fully understand the tax implications of any investment decisions.

About the author: Yves Kuhn has held his present role since June 2012; from 2009 to 2012 he was senior investment manager, emerging markets, Swisscanto group; from 1998 to 2009 he was co-founder and CIO at Fabien Pictet & Partners. He obtained an MBA from Erasmus University Rotterdam School of Management.