At a crossroads as rates rise? Here’s what a bond indicator is telling us
Rising government bond yields have presented more room to manage the impact of rate hikes. How big is this leeway?
Income investing remains relevant in the current market environment as a way to reduce the volatility of a portfolio.
The availability of yield opportunities, particularly in fixed income sectors, has starkly improved following a challenging 2022. But market volatility remains elevated amid rising global interest rates and rising recession fears.
These factors highlight the importance of an active, well-diversified and quality-focused approach to investing in income.
Role of income investing: a cash flow buffer for volatile times
The total return of an investment typically consists of two components: price appreciation and income. The latter is usually paid in the form of coupons from bonds or dividends from stocks1.
Dividends and coupons are important sources of cash flow that could help mitigate price fluctuations or reduce the volatility of a portfolio. This is especially useful during periods of high market turbulence and elevated uncertainty. While these payments do not imply or guarantee a return, they can also boost the total return1.
Income in the context of a well-diversified portfolio, is akin to a cash flow buffer that can help partially offset volatile or stagnant asset prices.
Income in action2
Although it is not indicative of current or future trends, the historical total return composition of the S&P 500 index can better illustrate this point. Returns generated from the distribution and reinvestment of dividends over the last nine decades have provided a buffer to the total return of the S&P 500 during periods of modest or weak price gains.
This was especially so in the 2000s, when equity returns were significantly marred by the burst of the Dot-com bubble in 2000 and the impact of the Global Financial Crisis in 2007-2008. The S&P 500’s total annualised return over the 10 year period ending December 2009 was -0.9%. But this was only because the annualised income return of 1.8% had partially offset the annualised capital loss of 2.7% over the same decade.
Looking back, we found that returns from income formed a sizeable share of the index’s total return in decades when capital or price gains were relatively muted, such as the 1940s, 1960s and 1970s. While income is still a critical component of total return over the long run, its characteristic as a potential downside buffer will likely remain relevant against the current volatile backdrop.
Chart 1: S&P 500 historical total return composition through the decades2
While income opportunities abound, volatility remains elevated
Likewise, from a multi-asset portfolio perspective, income generated from a variety of instruments including stocks and bonds can act as a buffer during periods of elevated asset price volatility.
This may prove critical as market volatility remains high, as evidenced by the elevated Merrill Lynch Option Volatility Estimate (MOVE) index – a gauge of bond market volatility – and the Volatility Index – a gauge of the underlying volatility of the S&P 500. Even for a traditionally defensive asset class like fixed income, volatility has surged faster than equities. Volatility is still poised to stay elevated as markets work through a challenging macro setting, marked by stickier inflation, rising global interest rates, elevated geopolitical risks and rising recession fears.
Chart 2: Volatility remains elevated across both equity and bond markets
Yet through the trials and tribulations of a volatile 2022, there is a silver lining – the availability of income opportunities has meaningfully improved. A revaluation of both equity and bond markets has led to opportunities for higher dividend and bond yields.
Notably, the repricing in fixed income markets has been rather aggressive, leading to a rise in yields across a wide array of fixed income sectors year-to-date (as of 30 September 2022). As can be gleaned from Chart 3, after a bruising nine months, yields have increased across most fixed income sectors which could cushion the impact of further increases in interest rates.
Chart 3: After a bruising nine months this year, yields have increased meaningfully across most fixed income sectors
Nevertheless, these opportunities come with risks. Dividends are not guaranteed while higher yielding bonds tend to carry higher credit risks. With economic momentum slowing and financial conditions tightening, managing these risks will become increasingly important. Investors are once again faced with the perennial challenge of having to balance the potential rewards of significantly higher yielding assets with the risks of an uncertain macro environment.
Seeking opportunities for yield
This market environment underscores three key points.
Robust bottom-up security selection remains critical to pick higher quality assets with good yield potential on a risk-adjusted basis, both across equity and fixed income asset classes.
Diversification across and within asset classes as well as regional markets is critical to smooth out market volatility and take advantage of yield opportunities from a variety of sources.
The flexibility to adjust allocations and nimbly respond to changing market conditions is essential to navigate a more uncertain market environment.
The above considerations suggest that active management has a key role to play in navigating the risks and opportunities ahead.