(YieldReport originally published this article and referred to Obsidian Capital as a Johannesburg-based asset manager. The Obsidian Capital referred to in this article is based in Melbourne and it is not connected with Obsidian Capital in Johannesburg.)
As interest rates and yields fall, investors may seek to maintain previous income levels from their investment portfolios. Investors who have become accustomed to a certain level of income from their portfolio may search for assets which produce more income than the assets they are holding. The result is typically a move from assets which have suited the investor in the past and into assets which previously had been dismissed as being too risky.
Ken Liow is the principal of Obsidian Capital, an asset manager based in Melbourne. He is also the independent chair of the Melbourne-based Realm Investment House Risk Management Committee. He discusses this move and some of its consequences. In his paper, “An Answer to Client Short–Termism and the True Costs of Yield-Targeting”, amongst other things he discusses what he refers to as “yield targeting” and the possibility it leads some fund managers to produce lower total returns over the economic cycle.
Investors, especially private investors, have an affinity for term deposits offered by local banks. However, term deposits come with a problem and that is term deposit rates have rarely been lower than they are today. Rates fell in the wake of the GFC and, ten years later, they have reached historically-low levels.
The logical thing to do is to find alternatives. Some investors have moved, or are considering moving, to other types of investments which pay interest, such as credit funds managed by professionals. Investors have not been looking for an “at call” account and some period of “locking it away” was considered to be part of the arrangement. “Investors who initiated or increased exposures to credit investments in the post GFC period may have viewed them as a form of high-yield term-deposit.”
What is yield targeting? As the term suggests, it is the targeting of a yield first and then adjusting duration (term) and risk settings in order to achieve that target. All things equal, shorter-term rates are lower than longer-term rates and securities with lower credit ratings have higher yields (interest rates) than securities with higher credit ratings. (Not always; value investor seek out these discrepancies and arbitrage them away.) Yield targeting suggests the process involves choosing the rate and then accepting the optimal combination of credit rating and duration which come with it.