In the world of finance and investing, the term yield chasing refers to the practice of pursuing higher returns (yields) by investing in assets or securities that offer relatively higher interest rates, dividends, or returns. 

While this strategy might seem appealing in the short term, it often comes with added risks that investors need to consider carefully.

In this article, you will get to know many things about what yield chasing is, the reasons why investors engage in it, the risks involved, and how to approach it prudently.

What is Yield Chasing?

Yield chasing occurs when investors seek out investments with higher yields (interest rates, dividends, etc.) compared to other available options.

The desire for higher returns can drive investors to put their money in assets that may seem attractive due to their ability to offer better income, but these assets may also carry more risk.

For example, investors might turn to riskier assets, such as high-yield bonds (also known as junk bonds), real estate investment trusts (REITs), or certain foreign currencies, as they promise higher returns than more traditional investments like government bonds or blue-chip stocks.

While yield chasing may be driven by the goal of maximizing returns, it’s crucial to remember that higher yield often correlates with higher risk.

Investors are often willing to take on these additional risks in the hope of receiving greater income from their investments.

Why Do Investors Chase Yields?

Several factors influence investors to chase higher yields:

1. Low Interest Rates Environment

In times of low interest rates, particularly in developed economies like the U.S. or the Eurozone, traditional fixed-income investments such as government bonds or savings accounts may offer paltry returns.

For instance, after the global financial crisis of 2008, central banks around the world slashed interest rates to stimulate economic growth, which led to lower returns on safer investments like treasury bonds.

As a result, many investors look for higher yields in riskier assets to generate more attractive returns. Corporate bonds, high-dividend stocks, and emerging-market investments can offer the kind of returns that are hard to find in more conservative investments.

2. Hunting for Better Returns

Another key reason for yield chasing is the basic drive to maximize returns. Investors, especially those managing funds for themselves or others, often feel pressure to perform well, particularly when markets seem stagnant or when traditional investments aren’t yielding much.

For example, retirees relying on income-generating investments might be more inclined to chase yields to maintain their lifestyle and supplement their income, especially when their current portfolio no longer generates enough earnings to meet their needs.

3. Market Sentiment and Herd Behavior

In many cases, investors follow the herd mentality. If a particular sector or asset class begins to offer higher yields, many investors might jump in, not wanting to miss out on potential gains.

This collective behaviour can drive up the demand for certain assets, thus further increasing yields and pushing others to follow suit.

Examples of Yield Chasing

1. High-Yield Bonds (Junk Bonds)

High-yield bonds, or junk bonds, are bonds issued by companies with lower credit ratings. Because of their increased risk of default, these bonds offer higher interest rates (yields) to attract investors.

In a low-interest-rate environment, many investors are drawn to the potential for higher returns from junk bonds, even though they carry a higher likelihood of loss if the issuing company faces financial troubles.

2. Dividend Stocks

Stocks that pay high dividends are often attractive to income-seeking investors.

However, if a stock’s dividend yield is much higher than that of its peers, it might indicate underlying financial issues, such as a company trying to attract investors by offering unusually high payouts.

In some cases, companies with unsustainable dividend payouts may face trouble, leaving investors vulnerable to capital loss.

3. Real Estate Investment Trusts (REITs)

REITs can offer high yields, especially those invested in commercial properties. However, in pursuit of higher returns, some investors might end up investing in riskier REITs exposed to volatile markets or properties with lower-quality tenants.

Economic downturns, rising interest rates, or market disruptions can lead to poor performance, leaving yield-chasing investors with significant losses.

4. Emerging Market Investments

Emerging markets often offer higher returns than developed markets, particularly in areas like bonds, equities, or currencies.

However, these markets come with risks such as political instability, currency fluctuations, and limited financial transparency.

Investors chasing higher yields may be drawn to these markets without fully understanding the risks involved.

The Risks of Yield Chasing

While chasing higher yields can be tempting, it comes with significant risks. Here are a few of the primary dangers:

1. Credit Risk

Higher yields often come with higher credit risk, especially when it comes to corporate bonds or junk bonds. If the company issuing the bonds experiences financial difficulties, it may be unable to pay back the debt, leading to defaults. Investors who were chasing high yields may lose both their income and principal investment.

2. Market Volatility

Assets that offer high yields tend to be more volatile, meaning their prices can fluctuate widely in a short period of time. This volatility can result in investors losing money quickly if market conditions shift unexpectedly.

3. Liquidity Risk

Some higher-yield investments, such as certain real estate or niche bond funds, may not be as liquid as more traditional investments. This means it can be harder to sell these assets quickly if you need to exit your position or if the market conditions worsen.

4. Overvaluation

In some cases, yield chasing can lead to the overvaluation of certain assets.

For example, if too many investors flood into high-yield sectors or assets, it can artificially inflate their prices, which leads to an unsustainable situation. When the market corrects, those who have chased the yield may suffer from significant losses.

5. Interest Rate Risk

For income-focused investments like bonds or REITs, rising interest rates can reduce the value of these assets.

As interest rates rise, the fixed income offered by these assets becomes less attractive compared to new investments with higher yields.

Investors who are chasing yields in a low-interest-rate environment may find themselves at a disadvantage when rates increase.

How to Approach Yield Chasing Prudently

While yield chasing can be dangerous, there are ways to approach it prudently and reduce the risks associated with this strategy:

1. Diversification

One of the most effective ways to mitigate risk when chasing yields is to diversify your portfolio across different asset classes, sectors, and geographies. By holding a variety of investments, you reduce the impact of a poor-performing asset on your overall returns.

2. Do Your Research

Before diving into yield-heavy investments, it’s essential to do thorough research. Evaluate the risk associated with the investment and ensure that the high yield is sustainable.

If you’re considering bonds or REITs, make sure you understand the creditworthiness of the issuer and the underlying assets.

3. Consider Risk Tolerance

It’s important to understand your risk tolerance before engaging in yield chasing. If you’re risk-averse, focusing on safer, lower-yield options may be a better fit for your financial goals. Higher yields often come with the potential for loss, so ensure that you’re comfortable with the risks involved.

4. Stay Disciplined

Yield chasing can sometimes lead to emotional decision-making. Stay disciplined in your approach to investing, and avoid jumping into high-yield assets simply because they seem attractive at a given moment.

A clear investment strategy, coupled with an understanding of your goals, will help you make more rational decisions.

5. Reevaluate Your Strategy

Markets are dynamic (it keeps changing), and what may seem like a high-yield opportunity today may not be the best option tomorrow. Regularly review your investments and adjust your strategy as necessary to ensure that you are not taking on unnecessary risk.

Conclusion

Yield chasing can be a strategy to boost returns, especially in low-interest-rate environments. However, it is not without its risks.

Investors should always weigh the potential rewards against the risks, carefully research their investments, and consider their long-term goals and risk tolerance.

By diversifying, staying informed, and maintaining discipline, investors can approach yield chasing in a way that aligns with their financial objectives without exposing themselves to undue risk.