Although there are options available to generate a higher income, in investment – as in life – there is no such thing as a free lunch.
The chart below will not provide much encouragement for those who are hopeful that this is a temporary phenomenon. Over the past 30 years, markets have consistently expected yields to rise, and have been consistently disappointed. The market is now questioning whether the “lower for longer” catchphrase should in fact be changed to “lower forever”.
Exhibit 1: Euro interest rates and market-based expectations of future interest rates
Understanding the menu
It is still possible to find higher-yielding assets (see the chart below). Investors could choose longer-maturity government bonds, or corporate credit. Yet given low yields across much of the fixed income world, investors are increasingly looking to the income that is available from equities. Stock markets across the globe are offering dividend yields that stand comfortably above the yield available on developed market government bonds. Yields on European indices - especially the FTSE All-Share - look particularly attractive. As the hunt for income intensifies, attractive dividends could well be a catalyst for inflows to return to European stock markets following a prolonged period of the region being out of favour.
Exhibit 2: Asset yield comparison
Although there are options available to generate a higher income, in investment – as in life – there is no such thing as a free lunch. Higher income comes with higher risk. While an economic downturn doesn’t seem imminent it is essential that investors understand and are comfortable with the risk that comes with these assets. Investors don’t want to find that achieving ample income today results in a nasty bout of indigestion when the market next goes through a period of turbulence.
The purpose of this piece is to understand the risks associated with the different income choices on the menu before considering some options to achieve a more satisfying mix.
The chart commonly used to capture the risk/return trade-off faced by investors is shown in the chart below, which plots historical returns alongside the volatility each asset class has experienced.
Exhibit 3: Historical risk vs. return for selected asset classes
%, annualized return 2004-2019 in EUR
However, the term “volatility” can feel opaque. It might be more helpful, or feel more tangible, to understand exactly what happened to these assets during past periods of market turbulence. The chart below considers the behaviour of credit and equities during the last three US recessions. We focus here on US asset classes due to data availability for credit indices but we believe that the conclusions are similar for European markets, given the relatively close relationship over time.
The size of drawdown and the time taken for assets to recover their losses varied significantly. The recession of the early 1990s was mild and declines in risk assets were recovered relatively swiftly, primarily thanks to the swift pace of the economic recovery once a brief surge in oil prices had subsided. In comparison, equity market declines in 2001 and in the global financial crisis lasted far longer: it was necessary to wait for over three years in both instances if an investor wanted to avoid selling below the previous peak. Somewhat surprisingly there is no clear link between the starting valuation (shown in the table by spreads and price-to earnings (P/E) ratios) and the size of the drawdown in these three episodes. This lack of a clear relationship between valuation and drawdown emphasises the importance of other factors, especially the extent to which central banks step in to support the market, in determining the size of a market move.
Exhibit 4: Comparison of previous US recessions
Another way of considering the experience of investors in the different asset classes over this period is shown in the four charts below. In short, these charts show that investors who are focused on annual income and have a high degree of tolerance to the gyrations in their capital position are better suited to higher risk options for higher incomes. Those that might need to access capital or have little tolerance for swings in capital values will need to accept lower incomes.
Exhibit 5A: US Treasury annual returns, 1990-2019 Exhibit 5B: US investment grade credit annual returns, 1990-2019
Exhibit 5C: US high yield credit annual returns, Exhibit 5D: US equity annual returns, 1990-2019
Increasing the options on the menu
Of course, high yield credit and equities are not the only options available to investors looking to boost income in their portfolios. But whatever the asset class, investors cannot find higher yields without taking on higher risk in some form. With no easy options, investors may be best positioned by adopting a diversified approach that incorporates a range of different risks.
Within fixed income, another income option is emerging market debt (EMD), which received record inflows in 2019. EMD has historically been more volatile than developed market credit, although the universe has matured significantly over the past decade: the number of countries in the JP Morgan EMBI Global Index has increased from 32 countries ten years ago to over 70 today. The introduction of five Gulf Co-operation Council (GCC) countries in 2019, along with the phasing out of Venezuela, has further improved the index quality, which has been reflected by a decrease in the extra yield-pickup available from EMD assets. Local currency yields are typically higher than US dollar-denominated hard currency debt, but clearly come with added risks from extra foreign exchange volatility.
Securitised credit is another key component of the income opportunity set: securitised assets are one of the largest and most liquid fixed income asset classes, making up around 30% of the total US fixed income market today. The term “securitisation” – a security whose value is linked to a pool of underlying assets - will for many bring back memories of the derivatives that proved so problematic during the global financial crisis. Yet underwriting standards have improved significantly since the crisis and broadly remain in good shape today. Securitised assets are also a helpful tool to gain exposure to the consumer, which for several years has been a stalwart of this expansion across developed markets, and arguably stands in better health than the corporate sector across many developed markets today.
Outside of fixed income, real assets – and especially infrastructure – have gained strong traction with income-focused investors in recent years. The relatively young nature of this alternative asset class makes historical analysis of different economic scenarios more challenging, but the data that exists for infrastructure assets points to relatively robust performance through the global financial crisis. This is thanks to the combination of stable and forecastable cash flows, coupled with a high proportion of total return generated through income. Infrastructure can also improve portfolio diversification, yet again there is a trade-off involved - namely the illiquidity associated with unlisted private assets.
As the chart below shows, with this expanded opportunity set, the list of options to achieve income above inflation looks a lot tastier.
Exhibit 6: Asset yield comparison
In summary, investors that remain in cash-like deposits are likely to remain starved of income for the foreseeable future. While there is no simple solution to the challenge of boosting portfolio income while limiting risk, investors should consider embracing the broadest menu of options possible. Core government bonds are still a key part of a balanced portfolio, yet their role is now much more about insurance than providing income. Credit and equities will need to provide a higher proportion of total income relative to history, but investors should also consider combining the broadest possible range of assets to take advantage of the merits of diversification and optimise the risk-return mix. Income-hungry investors should deploy the culinary tips of the Spanish “tapas” – combine a wide range of dishes for the most appetising meal.