Faced with the choice of investing in a 10 year government bond yielding 3.2% as they are in Australia now, or allocating to commercial property with a 6.6% average yield and capital growth of, say, 2.5% pa (i.e. inflation) giving a total return of 9.1%, an investor might well conclude the latter makes more sense.
In fact, looked at this way the property risk premium – i.e. the return potential property provides over current bond yields – at about 5.9% is about as high as it ever gets.
And of course, the same logic can be applied to investment in assets such as infrastructure, shares and corporate debt.
But is the chase for yield on borrowed time?
Is it wise for investors to behave this way? Probably yes… until it goes too far, bond yields surge or growth disappoints.
Has it gone too far?
Inevitably the search for yield will be pushed too far as it was last decade. Perhaps the greatest risks are seen to be around corporate debt where the gap between US investment grade and junk bond yields and US government bond yields has fallen to the range that prevailed prior to the GFC.
However, credit spreads remained around these narrow levels for many years in the mid-1990s and mid-2000s before trouble arose. Nor have credit lending standards deteriorated like they did prior to the GFC.
In terms of equities, there has certainly been a narrowing in the gap between the forward earnings yield on shares and bond yields. But, as can be seen in the next chart, this gap – or a guide to the risk premium shares offer relative to bonds – still remains relatively wide compared to pre-GFC levels.
And finally for real assets (if commercial property is a guide), as indicated earlier, the risk premium offered by commercial property relative to bonds remains about as wide as it’s ever been.
So overall, it’s hard to argue the search for yield has gone too far. That said, corrections like the one we have seen in shares and corporate debt markets during the last month are healthy in ensuring this remains the case.
What about the risk of an upswing in bond yields?
The events of the last month, with renewed worries global growth and deflation, tell us that the immediate threat from higher interest rates is low. The US is closest to raising rates but global risks and a strong US dollar importing low inflation to the US could see that pushed out to the second half of next year.
Australia is under no pressure to raise rates, with sub-trend growth and low inflation, and probably won’t start raising rates till after the US and for both it will be gradual. Rate hikes aren’t even on the horizon in Europe, Japan and China.
What about the risk of slower growth?
Slower growth is perhaps a bigger risk globally, with the global economic recovery remaining fragile. In the absence of a major external shock or a major monetary tightening, however, it’s hard to see a sharp slowing in global/Australian growth.
What to watch?
Our basic assessment is that the search for yield hasn’t yet gone too far. Key indicators to watch for signs that it has include the following:
So far so good, but they are all worth keeping an eye on.
What does it all mean for investors?
While the yields and return potential across most assets has continued to fall, shares, non-residential property and infrastructure continue to offer better prospects than low yielding cash, government bonds and term deposits. Some value has also been returned to corporate debt following the recent back up in corporate bond yields.
Shane Oliver is head of investment strategy and chief economist at AMP Capital. This article first appeared on Property Observer.
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