A multi-income journey into the emerging high-yield potential
Income investors like us have stayed the course as we ride through the four seasons. Where do we see income opportunities?
Q1. WHY WOULD A MULTI-ASSET INCOME STRATEGY1 STILL HOLD?
The search for quality income is more challenging than ever. Aggressive global monetary easing has pushed rates way down in the traditional go-to sources of yield.
Multi-asset income strategies could give investors access to multiple and diversified income sources which are critical for identifying income opportunities efficiently. More recently, there were periods in which diversification did not function as it has traditionally. Having said that, we still believe in diversification and in multi-asset investing for opportunities to generate optimal risk-adjusted return2.
Our strategy performed2 well in 2009 following the Global Financial Crisis, driven by our ability to invest in pricing dislocations across asset classes including high yield (HY)3, non-agency residential mortgage-backed securities (RMBS), convertible bonds and other areas. The aggregated flexibility across geography, asset class and capital structure worked to our favour and we hope to be able to do the same in the wake of this crisis.
Q2. HOW IS YOUR MULTI-ASSET INCOME STRATEGY POSITIONED1,4?
We entered 2020 with a more conservative risk exposure through reduced equity allocation as we are mindful of the potential headwinds that could emerge. We will remain defensive until there is greater clarity on the severity and duration of the pandemic.
Against this backdrop, we have further strengthened the resilience of our income portfolio in the first quarter, whereby we have:
Q3. COMPANIES ARE ANNOUNCING DIVIDEND CUTS, HOW WILL THAT IMPACT YOUR STRATEGY1,4?
That is definitely top of mind. In managing this strategy, our intent is to pay out from gross yield5,6 and not capital – that continues to be the intent today.
With that said, we have and will continue to see dividend cuts and suspensions in an array of regions and sectors. Most significantly in Europe, but also in emerging markets (EM) to some degree. That is why we continue to have a preference for defensive US equities where there is less expectation of dividend cuts.
It is important to distinguish the reasons for those dividend cuts. Are they being encouraged by regulators or governments, such as the European Central Bank’s (ECB) guidance to European banks to cut dividends? Or are they prudent, proactive steps by companies to shore up short-term liquidity?
Our focus at the strategy level is to buy high-quality companies with relatively attractive levels of yield - where these yields are sustainable, with the potential to grow over time. Most of the companies that we hold which have experienced cuts are expected to resume payouts in due course given their strong balance sheets and payouts. The overall viability of these companies remains our long-term focus.
Q4. HY CREDITS ARE TROUBLED BY THE PLUNGE IN OIL PRICES AND CONCERNS OVER DEFAULTS. WHAT IS YOUR EXPOSURE1,3,4,6?
We have seen a massive oil sell-off leading to a price drop and that is an important part of the US HY market. Even prior to this, however, the HY exposure in our income portfolio was already defensively positioned.
We believe there is potential for total returns with spread compressions and attractive yield, further supported by accommodative Fed actions.
On HY defaults
We haven’t realised any default losses in European HY credit. On a par-weighted basis in our US HY exposure, we are seeing 3.3% default rate, higher than the 2.8% default rate of the index7. However, even for the issuers we hold that have defaulted, these are in more senior parts of the capital structure, and therefore the recovery rates are higher than the index.
Going forward, our HY portfolio managers are expecting a default rate of 7%-10% in the US and 5%-8% in Europe for broad markets. Based on historical experience, we would expect to experience roughly half of the index default rate and somewhere between 25%-50% of the default rate in Europe.
Q5. WHY DID YOU DIVERSIFY INTO IG CREDITS THIS YEAR1,4?
We have built up our allocation from about 0% at the end of 2019. We find IG corporate relatively attractive because spreads have widened significantly since February, by about 100 basis points. These companies have strong balance sheets and are not experiencing fundamental concerns facing some sections of the HY market.
The ECB’s and the Fed’s asset purchase programmes are committed at buying IG corporates, that has been a game changer, providing support.
Our preference is for higher rated companies offering an attractive absolute level of yields with high quality. We are selective with our exposure to higher quality triple B and triple B+, complementing that with lower-grade single A.
Q6. THERE WERE LIQUIDITY CHALLENGES IN SECURITISED ASSETS, WHAT IS YOUR OUTLOOK NOW1,4,8?
We had a modest allocation to non-agency securitised assets predominantly in RMBS. That allocation was to gain exposure to a strong US consumer and a healthy US housing market and a diversifying holding to our other credit exposure tied to corporate balance sheets.
Historically, in turbulent markets, those assets have traded with little equity sensitivity given different drivers of return. Unfortunately, the combined impact of the pandemic pushing the economy into recession, severe liquidity challenges and the forced de-leveraging in the securitised market led to an indiscriminate sell-off. The higher-quality names were easier to sell as investors liquidated, and prices got to distressed levels very quickly.
The fallout of the pandemic introduces fundamental concerns about the strength of the consumer and the housing market, including job losses and potential inability to make payments on houses and cars. However, we are not leaving the sector.
The significant monetary and fiscal stimulus support will bolster these sectors. Most of our exposure was in RMBS, where the Fed has stepped in to support the housing market. We also believe our higher quality basis is still valid, that the price declines were exaggerated by the liquidity panic.
Now at dislocated prices, we are actually starting to look for more opportunities in fundamentally stronger sectors. We are keeping our exposures but making some rotations.
Q7. IS THE REBOUND IN THE EQUITY MARKETS SO FAR SUSTAINABLE? ARE THERE SIGNALS TO ADD BACK RISK1,6?
It’s really tough today to know exactly what markets are pricing-in as valuations are subject to earnings. Forward-looking earnings are uncertain for now as companies are withdrawing from providing guidance.
The gap between analyst estimates and reports is historically very wide, and so it is hard to get a handle on how attractively valued equities are currently. What gets realised will determine what’s attractive. Generally, the market is looking pass 1Q 2020 and 2Q 2020 corporate earnings, and is now looking into 2H 2020 and 1H 2021.
The rebound in equity markets from their lows have been extreme and very quick. At this point, equity markets will likely take a breather and be range-bound for now. US equities have recovered more than EM equities overall, but sectors such as US small-caps are still lagging. We would not say that US equities are undervalued, at this point.
From an equities perspective, we have reduced risk and have since been sitting tight with our overall exposure. We are not yet comfortable taking on more equity risk. If we were to gain more confirmation of a successful restart of the global economy, we would feel more confident adding back risk in equities where we see attractive valuations. That could include areas in EM, particularly Asia, where recovery, in our view, is within sight.
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Overall, we believe that multi-asset income strategies remain important as the search for quality income is now harder than ever. Aggressive global monetary easing has pushed rates way down in the traditional go-to sources of yield. Access to multiple and diversified income sources across geography, asset class and capital structure remains critical for identifying income opportunities efficiently. We still believe in diversification and in multi-asset investing for opportunities to generate optimal risk-adjusted return2.