Income beyond fixed income
- The struggle to find income is not new, but is currently complicated by expectations of rising government bond yields and heightened inflation, creating risks for holders of core government bonds or longer duration assets.
- The strengthening economic recovery has bolstered the earnings outlook. This should lead to a recovery in dividends as companies return capital through higher dividend payouts.
- For those looking for potentially more stable income streams with a lower correlation to equities, alternatives, such as real estate and infrastructure, present predictable inflation-linked income options.
- The opening of China’s financial markets has led to greater investor interest in its relatively higher-yielding government bonds.
- Not only do Chinese bonds have a higher yield than many developed markets, but also they do not exhibit the same risks as other EM government bonds, with a much lower correlation to the flagship Bloomberg Barclays Global Aggregate Index.
Fixed income to low income
Years of financial repression by central banks as well as longer-term secular forces have created a downdraft of income in the traditionally held parts of the fixed income market.
- There are still sources of income within the fixed income market, such as U.S. HY bonds or EM debt, or the relatively newer China government bonds. But investors must be more selective in their allocations given market and idiosyncratic risks to these assets.
- Meanwhile, the risk/reward of holding higher-quality fixed income assets, such as core government bonds and IG debt, has become less appealing as higher duration assets are susceptible to capital losses as interest rates rise.
- As earnings growth is expected to rise, dividend growth is expected to increase as well. Investors should not only focus on the absolute level of dividend yield but also the prospects for it to grow over time.
Divide(n)d we stand
The popularity of growth stocks, traditionally lower dividend payers, has reduced the dividend component of total shareholder return.
- In the U.S., for example, 22% of the 10.2% average total return since 2002 came from dividends. In the last five years, this number has fallen to 14% given the boom in U.S. growth stocks. However, the change has not been as swift in Asian markets as dividends have still accounted for 24% of total returns in the last five years (28% since 2002).
- This trend may be starting to turn as elevated valuations in growth sectors greatly diminish return prospects and investors rotate towards value and higher dividend payers.
- In the depths of the COVID-19 pandemic, dividend forecasts collapsed alongside earnings expectations. Regulatory changes also prevented some companies from paying or increasing dividends during the period. However, a V-shaped recovery in many economies has led to a sharp increase in dividend forecasts, which are noticeably stronger in Asian markets.
- This page shows the yield that can be earned across different asset classes. U.S. Treasuries offer one of the least attractive options as higher income can be found in higher-dividend equities and extended segments of the fixed income market.
- Extending into some riskier bond assets or added equity income can increase overall portfolio correlation to equities. Alternatives, such as transport, infrastructure and real estate, can offer both higher yield and increased diversification.
Looking beyond bonds for income means considering non-traditional assets. Alternative assets present their own challenges but offer similar characteristics for income and portfolio diversification.
- In recent years, investors have been increasing their allocations to alternatives as such assets offer the prospect of increased returns, steady income and, in some cases, bond-like diversification.
- Real assets, such as infrastructure, real estate and transport, are assets that have steady cash flows that can translate to higher income. The contractual nature of these cash flows, often with high-quality counterparties, leads to more predictable income streams and lower return volatility.
- These assets may also be an inflation hedge as the cash flows are indexed to rising inflation rather than having to absorb it.
- Some segments of the bond market can still be tapped to provide income in portfolios, such as HY bonds and EM debt. However, investors will increasingly have to look beyond the bond market for income.
- The strength in earnings growth means companies can reward shareholders with higher dividends as well as reinvest for growth. Higher-yielding equity markets are trading at elevated valuations, and this is an option that should be considered.
- For investors who can allocate to illiquid assets, the stable cash flows from real assets, such as infrastructure, transport and real estate, may be a viable source of reliable income and bond-like portfolio diversification.