Air getting thinner as yield hunt reaches new terrain

LONDON Fri May 9, 2014 9:20am EDT

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LONDON (Reuters) - Investors may be stretching too far for higher returns in what some are terming a worldwide "Yield Grab-athon", closing their eyes to the risk of heavy potential losses when interest rates eventually drift higher.

This week's message from Federal Reserve chair Janet Yellen that the U.S. economy still needed support has only served to spur on the yield fever that has taken hold in recent weeks.

Markets are clearly in no mood to heed the other part of Yellen's message - that low rates could be fuelling risky "search-for-yield behavior".

Rock-bottom interest rates in the United States and elsewhere in the developed world are allowing investors to raise funds cheaply. They then pour the cash into everything from peripheral euro zone sovereign bonds to junk and exotic debt, regardless of valuations or liquidity.

But when the music stops, losses could be large - and the first Fed rate hike is expected to come only a year from now.

"We're now in a 'Yield Grab-athon' as everyone moves down on the credit structure, giving up the safety aspect of fixed income in the search for yield," said Grant Peterkin, head of absolute bond returns at Lombard Odier.

"But fundamentals do not support valuations at these levels. You have to ask yourself who has been buying these bonds. If it's levered money ... when the cost of funding goes up you might see capitulation of these positions."

The renewed yield rush pushed Italian, Spanish and Irish 10-year bond yields to fresh record lows on Friday. All three countries were prominent in the euro zone's debt crisis - Ireland has recently exited a bailout - and remain very indebted with patchy economic growth.

Emerging dollar bond spreads have fallen below 300 basis points over Treasuries for the first time in a year and many sovereigns and corporates, including previous defaulters like Pakistan, are tapping investors for fresh funding.

The iTraxx crossover index, a key measure of credit market sentiment based on credit default swap rates of 50 mostly liquid junk names, stands at 261 bps, near a seven-year low of around 252 bps hit in March.

Greece, which nearly crashed out of the euro zone two years ago, returned to the market in April, paying just 4.95 percent for five-year funds.

"It's mind-boggling that Greece can borrow as if it never had a problem. We think it's increasingly risky and I wouldn't be inclined to buy peripheral debt here," said Iain Stewart, investment manager at Newton Investment Management.

"We're in a world where really extreme monetary policies are being used to tackle what we think are structural problems, creating distortions ... Almost certainly we will see bubbles."

FINANCIALISATION

The scramble for yield means investors are having to cast their nets wider in search of returns.

BlackRock thinks municipal bonds offer some upside, while there is value to be found in mortgage-backed securities - shunned for years by many investors because of their role in triggering the global financial crisis that began in 2007.

"There are few genuine bargains in fixed income today, but we would suggest that investors continue to focus on areas of the market that offer better relative value," said Russ Koesterich, global chief investment strategist at BlackRock.

On the euro zone's periphery, Lombard's Peterkin only wants to hold Italian government bonds, because of their ample liquidity, and prefers to play the yield curve by shorting front-end government bonds and buying longer-dated ones.

And in event of a market mishap he says his portfolio is liquid enough to liquidate all of the holdings in one afternoon.

Peterkin added that some investors are buying highly risky and illiquid instruments like CoCos (Contingent Convertibles) or Cov-lite (Covenant light) loans, which are similar to the type of investments that were popular before the credit crisis.

"It's bit like 2006 and 2007 again. When people get out, they queue up to the door, the queue gets bigger and the door gets smaller."

CoCos are a new type of securities that are typically issued by low-rated companies and banks and convert into shares should their issuers run into trouble. Cov-lite loans offer attractive yields but less protection for investors than is traditional.

It was only last week that London's red-hot property market struck a new record with the sale of a 140 million pound ($237.34 million) unfurnished apartment.

"We think what we call financialization is going on - the financial system gets bigger and bigger, effectively subsidized by the government. Then it becomes difficult to reverse the policy," Newton's Stewart said.

"We see this happening all over, not just in real estate but other asset markets, and that concerns us because there is a lot of leverage at financial institutions."

($1 = 0.5899 British Pounds)

(Editing by Catherine Evans)

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