Risk, Return and the Search for Yield – IMF F&D
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- Authors: JAY SURTI
- Published: June 1, 2021
Overview
- Author: JAY SURTI, deputy division chief in the IMF’s Monetary and Capital Markets Department.
- Publication: F&D Magazine, June 2021.
- Core thesis: Low safe-asset returns tempt savers and institutions to pursue higher-yielding, riskier investments—a “search for yield”—which can increase economic and financial instability.
How low safe-asset returns drive the search for yield
- The Treasury bill equilibrium interest rate (the rate of interest at which the amount of money demanded is equal to the amount of money supplied) is a key benchmark; it influences returns on long-term government bonds, bank deposits, company bonds, and shares.
- Returns on riskier assets tend to rise and fall in line with the safe asset return.
- The temptation to search for yield rises when the safe asset return falls to very low levels over a long period of time, as has been the case in Japan and several European economies for the past two decades.
Effects on households
- Low returns on savings lead to slower wealth accumulation and make life-cycle goals harder to achieve (examples: buying a home, saving for retirement, passing on wealth).
- Behavioral responses:
- Households may shift money out of savings accounts and into stock markets.
- Households will try to compensate by saving more and spending less.
- Exception noted: Japan — older and wealthier households, with less need to increase precautionary savings and greater capacity to search for yield, have invested in high-risk emerging market bonds and stocks.
Effects on firms and corporate balance sheets
- Firms might seek to boost income through speculative investments financed by debt because borrowing is cheap.
- Higher indebtedness makes firms more precarious when confronted by adverse shocks, increasing institutional vulnerability and the likelihood of economic and financial instability.
- Lower household borrowing and consumption reduce demand for goods and services, causing corporate sales and profits to slide.
Financial institutions and banking sector implications
- Financial institutions such as banks and insurance companies may make risky bets to maintain profits or survive; riskier portfolios increase the likelihood of loss.
- Bank lending to households declines as interest rates fall to very low levels.
- Net interest margins are squeezed: the difference between banks’ lending and deposit rates is reduced, driving down profits.
- Risks from cross-border expansion:
- Banks expanding abroad may face losses if risk management does not adapt to local challenges.
- Delegating operational decisions to local managers can complicate performance incentives, potentially inducing excessive risk-taking through unrealistic pay and promotion targets.
- Consolidation concerns:
- Consolidation of the banking sector through mergers or acquisitions can stifle competition.
- Reduced competition may increase borrowing costs, especially for households and small businesses, hindering consumption and investment and posing a setback for inclusive growth.
Cross-border spillovers and carry trades
- Since the dollar is a global funding currency, low interest rates in the United States generate search-for-yield incentives beyond U.S. borders.
- Firms from other countries may borrow in the United States to invest at higher returns at home (carry trade), which is financially risky if the dollar appreciates.
- Historical example: The “taper tantrum” of 2013 caused large emerging market firms to experience carry trade losses from dollar appreciation, materially denting firms’ market valuations and, in some cases, increasing volatility in domestic financial markets.
Benefits, risks, and policy implications
- Benefits of search for yield:
- Risky bets that pay off can increase income from savings and investment when interest rates are low.
- Such investments can spread capital to new markets.
- Risks and policy cautions:
- Policymakers must be alert to the dangers of speculative debt-financed investment.
- Some bets will inevitably go sour; the consequences for economic and financial stability can be severe when they do.
Source: Risk and Return: The Search for Yield, JAY SURTI, F&D Magazine, June 2021.
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