The desperate hunt for yield is back, and so is risk

February 24, 2011: 12:25 PM ET

Institutional investors are clamoring for some of the most maligned securities from the credit crisis, while individual investors are taking on more risk for steady income that beats Treasuries. Is it 2005 all over again?

By Nancy Miller, contributor

risk

Steady income, at what cost?

Investors are getting fed up with minuscule interest rates but remain nervous Nellies -- afraid to gallop into the stock market and afraid to hang back with their bonds.

Instead they hope they're entering a middle ground -- putting money into assets once assigned to investment purgatory in return for steady income. Institutional investors are keen again on bank loan participations, covenant-light corporate debt, exotic asset-backed securities, and all manner of commercial real estate. Individual investors, meanwhile, are seeking yield in dividend funds and certain bond funds that pay much higher than Treasuries.

It's not that investors are partying out there like its 2005, but it's close. Risk is mounting in almost every asset class as a result of the Federal Reserve's low interest rate policy. "Ben Bernanke has reignited the risk market," says Michael "Mish" Shedlock, a registered investment advisor for Sitka Pacific Capital and a popular blogger. "People are doing the same dumb things they did in 2006," he asserts. "There are no fundamentals for this. Just liquidity and sentiment. And when sentiment changes, liquidity will change with it because liquidity is a coward and it will disappear." How else can anyone account for the strong demand reported for this week's $3.7 billion taxable bond issue from Illinois, a state with a severely under-funded pension fund and the target of an SEC investigation?

It's a hunt for steady income, and it's happening on both the institutional and individual investor level. "People who would otherwise be in CDs or ultra-safe assets are taking greater risks," says Martin Fridson, Global Credit Strategist, BNP Paribas Investment Partners. "But people are not buying to get significant capital gains. They are hoping to get their coupons."

That hope is global. GLL Real Estate, the German-based real estate investor just bought an office building in downtown Washington, D.C., for $101 million from CoStar Group, a real estate firm that had purchased the building just one year earlier for $41 million. In a twist of irony, the original owner was the Mortgage Bankers Association, which was forced to abandon its spanking new building last year, leaving its $75 million mortgage much the way home owners abandoned their unaffordable loans: with the bank.

GLL wanted an income-generating investment, and it paid big for it. CoStar spokesman Chris Macke says the GLL deal is typical of the real estate market of the past couple of years: fully-leased properties in cities like Washington, Chicago, and New York, are in demand, with prices rising more than 30% from the bottom and even pushing beyond 2007 levels.

Institutional investors are also looking to hard assets to strike a balance between income and capital appreciation. Brett Hammond, chief investment strategist for TIAA-CREF, likes the top properties in the commercial real estate market, but he's also focusing on agriculture, timber, gas and oil, "something where we can get superior yield." Much of those investments are headed to an insurance annuity fund designed to rise and fall with interest rates, protecting investors against the vagaries of inflation, a new concern now in the face of rising rates. The annuity offers returns between 3% and 6% -- not exactly bell-ringers but appreciably better than US Treasury notes.

Mortgage-backed security, a dirty word no longer?

As the economy improves, and banks become more willing to lend, the market for commercial mortgage-backed securities is also warming up. Just last week, institutional investors scrambled to get a piece of a $2.2 billion private CMBS deal led by Deutsche Bank (DB) with UBS (UBS) and Ladder Capital. They paid up for the privilege. Spreads on the triple-A rated securities were about 15% tighter than comparable securities issued in last fall, which means they were pricier. The triple-B layer saw even more aggressive bidding: spreads were 295 basis points over the swaps rate down from 425 basis points, according to people familiar with the deal. (See also Let's try this again: Mortgage bond ratings return with scrutiny)

Size wasn't the only notable part of this deal – it was the diversity of loans within the portfolio and the location of the properties – about 91% in primary markets. But dig into the details and you'll see that leverage is creeping back. The loan-to-value ratio on the underlying portfolio of loans is 94%, according to Moody's Investors Service, up from the high 80s of recent deals. At the height of the real estate bubble, CMBS deals came whizzing through with debt service levels approaching 120%.

To find a stronger taste of 2005 in the marketplace, you'll need to go to the more exotic asset-backed security market and so-called "non-agency" residential loans -- that is, anything that isn't government-backed in the home market. "In the non-agency residential sectors the markets have rallied dramatically and arguably fundamentals are worse than they were in 2009," says Daniel J. Nigro, of Warfield Consultants. "Everybody is a yield pig."

Yields have dropped from a high of 15%-20% during the deep, dark days of the Great Recession to as little as 4%, he says. In the last month, investors have bid up prices on the super risky option-pay adjustable-rate mortgages by 5 to 10 points -- about 15% higher, Nigro estimates. Friendly reminder: Option ARMs enable borrowers to pay minimum amounts that can eventually eat away any equity they have in their homes.

Misplaced fear

Individual investors, still fearful of stock market volatility, are reaching out for more yield in different ways as well. Data from Lipper reveal that they are seeking better returns in bank loan participation funds offered by mutual fund firms like Oppenheimer (OPY) and Fidelity, which reset every 30 to 90 days. The 12-month yield on the loans, which are unrated and therefore riskier, was 4.53% as of 1/31/11, says Tom Roseen, senior Lipper research analyst. That's a huge spread to the one-year Treasury bill, which is currently yielding less than one-third of a percentage point. Roseen says individual investors are also headed to multi-sector income funds -- a "kitchen sink" array of bonds that have yielded 5.17% in the last year, he says. Funds that focus on qualified dividend income are also popular, in part because the retention of the Bush cuts mean that they get taxed at 15% versus 35% for pure bond income funds.

Some are saying that if there's a poster child for a bubble it's the high-yield debt market. Issuance remains on a record pace at $90 billion in the first five weeks of the year, according to data from Dealogic, even though yield spreads to comparable Treasuries have tumbled from about 725 basis points to 525 basis points. Martin Fridson argues the defaults on high yield are at historic lows: about 3% now versus 4.5% historically – which puts the spreads in a different light. Some are predicting that defaults could slide to under 2%, he adds.

Jeffrey Gundlach, head of bond fund manager DoubleLine Capital, worries that defaults are unlikely to remain low and that investors in riskier assets like junk bonds, commodities, and bank loans are in for nasty surprises. In fact, he still prefers government bonds to stocks: Sure, a stock might offer twice the yield as a Treasury but it is much more likely to drop 20% in price than its thin-yielding compatriot. He worries about the other markets, but he refrains from using the word 'bubble' to describe them. Investors have been rewarded for slowly extending out on the risk curve. But now "they are owning more and more of it when it's less and less attractive."

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