By Yiqing Lü
The global economy is heading into a period of steadily declining interest rates. At the beginning of 2000, the benchmark US federal funds rate hovered around 6%; as of December 2020, it was less than 0.1%. The Governing Council of European Central Bank, which sets the key interest rates for the Euro area, has also been steadily adjusting the deposit rate down to a historically low level of negative 0.5%, from around 3% in 2000. Although the Chinese economy has largely recovered from the hit of the Covid-19 pandemic, the People’s Bank of China also lowered Interest on Excess Reserves (IOER) by 37 basis points in April 2021. As global growth is widely expected to remain slower than in the past, most central banks will likely continue to set policy rates well below those that prevailed before the financial crisis.
While a low interest environment creates advantages for companies and people taking out loans or refinancing their mortgages, it can impose serious challenges for investors who seek income from investments. Both institutional and individual investors may exhibit a tendency for “Reaching for Yield” (RFY) in a low interest rate environment, which is an investment strategy or heuristic that leads to a greater fraction of wealth being allocated to riskier assets with higher yields.
Substantial evidence shows that various types of institutional investors prefer higher-yielding securities when interest rates are low. For example, money market funds take on greater risk by investing in longer-maturity and riskier asset classes in response to zero interest rate policies implemented by the Federal Reserve, even though these funds are designed to hold only safe, short-term assets and therefore are strictly regulated based on ratings and maturities. Similar evidence is also found in insurance companies: within each risk rating class, insurance companies tend to invest in the relatively higher-yielding corporate bonds. Such a strategy is consistent with regulatory arbitrage, as capital requirements for insurance companies are not based on the risk of each individual security but rather based on a broadly-defined risk system under which each rating encompasses a variety of securities.
Evidence of RFY among retail investors is scarcer. Recent research that uses randomized investment experiments on online survey platforms shows that low interest rates can lead participants to choose a significantly higher proportion of risky assets. Exploring a retail banking dataset, my own research, collaborated with my colleagues Guodong Chen, Christina Wang and Johnson Mo, also finds similar evidence among individual Chinese investors: they invest in higher-yielding mutual funds with higher risk ratings as the interest rate goes down, with the caveat that they do not pursue the riskiest category of mutual funds. What is also worth pondering over is our finding that the introduction of fintech, e.g., mobile phone banking, can exacerbate such an investment heuristic.
As a noticeable example of low interest rate regimes, Japan has had a zero interest rate since the late 1990s, and the 2008 global financial crisis prolonged its quantitative easing program. The household sector, in aggregate, shows a trend of divesting from cash and fixed-income securities, instead focusing more on equities. Japanese institutional investors, e.g., pension funds, significantly increased their holdings of foreign equities.
While it seems intuitive that investors want to seek higher-yielding assets when interest rates are low, the rationale behind it is not obvious and can differ significantly between institutional and individual investors. Under a loose monetary regime, as fund managers invest their clients’ rather than their own money, a motive to maximize profits combined with agency conflicts can result in RFY among institutional investors. Individual investors, however, are not subject to agency problems. Instead, they exhibit RFY likely due to a reference-based preference, which captures the observation that people may form reference points regarding investment returns. When interest rates fall below the reference level, people experience discomfort, and consequently take excessive risks to seek higher returns.
Last but least, the micro-level observation that RFY investors expose themselves to greater investment risks under low interest rates has important macro implications. Research shows that increased risk-taking by RFY investors could be crucial in the buildup of the endogenous boom and bust cycles in the economy when there is no central bank intervention. An increase in the accumulation of wealth or savings in a boom leads to a reduction in interest rates, which increases risk-taking that eventually materializes in a bust. The bust reduces savings and increases interest rates, starting again the process of wealth accumulation that leads to a boom. As a result, retail and institutional investors and, in particular, financial regulators should stay vigilant about the potential risk accumulation under a low interest rate environment.
* This article is not intended to serve as any advice for investment.