Finance and Investing: Reaching for Yield
Reaching for yield is a commonly used phrase in finance and investing. Strictly speaking, and in its narrowest sense, the phrase characterizes a situation in which an investor is seeking higher yields on his or her investments.
More specifically and more commonly, the phrase is applied to situations in which the investor chases higher yields without due regard to the added risk that he or she is usually incurring as a result. Indeed, investors who are aggressively reaching for yield often tend to show the opposite of normal risk aversion, instead of becoming risk loving in their choices, whether consciously or not.
Yield and Credit Crises
The financial crisis of 2007 to 2008 is the most recent example of a market collapse caused, in part, by widespread reaching for yield. Investors desperate for higher yields bid up the value of mortgage-backed securities to levels incompatible with their underlying repayment risk. When the mortgages behind these instruments went into arrears or defaults, their values crashed.
A general crisis of investor confidence ensued, causing sharp drops in the values of other securities and the failure or near-failure of many leading banking and securities firms.
Reaching for Yield and Financial Fraud
Investors who aggressively reach for yield are among those most susceptible to becoming victims of financial scams and schemes. Indeed, many of the great cases in the financial history of scams and frauds involve perpetrators, most famously Charles Ponzi and Bernard Madoff, who specifically targeted people who were desperately reaching for added yield on their money, dissatisfied with conventional investing opportunities.
In a low-interest-rate environment such as that which has existed in the aftermath of the financial and credit crises of 2007 to 2008, many institutional investors, such as insurance companies and defined benefit pension funds, have been under pressure to reach for yield. These low yields are due, in large part, to actions by the Federal Reserve and other central banks around the world to stimulate their economies in the aftermath of the 2007 to 2008 financial crisis.
Insurance companies and pension funds in this bind feel compelled to assume more risk to generate the returns necessary to meet their obligations. The result is a generalized increase in risk in the financial system.
Impacts on Bond Price
Insurance companies and pension funds are major buyers of corporate and foreign debt and thus are significant sources of funding for these entities. The buying decisions of these institutional investors thus have major implications for the supply and price of credit. The effects of their reaching for yield are seen in the pricing of new issues of debt and in the pricing of these same instruments in the secondary market.
In short, when these large institutional investors are actively reaching for yield, they bid up the prices of riskier securities, and thus actually decrease the rate of interest that riskier borrowers must pay.
Academic researchers have found that reaching for yield is most aggressive and obvious during economic expansions when bond yields normally are rising anyway. Even more, ironically, this behavior is more obvious in insurance companies that face more binding regulatory capital requirements.
Another counter-intuitive finding by researchers is that regulations designed to reduce risky investment behavior on the part of insurance companies actually spur reaching for yield. The key to this finding is the observation that even the allegedly most sophisticated schemes for risk measurement are highly imperfect, if not fundamentally flawed.