What’s more, even when the Fed completes its next rate hiking cycle (we expect the first liftoff before the end of this year) rates are expected to be lower than in prior cycles. Consider: Over the past three cycles, the Fed began hiking when the fed funds rate was an average 2.9% and ended when rates averaged 5.9%. The Fed’s current projections point to just a 3.1% policy rate at the end of 2017.
As they confront an extended period of relatively low rates, investors require a nimble approach to seeking income, deployed across a global opportunity set. A compelling income strategy begins with a thorough analysis of a security’s yield, risk and return characteristics. Four key themes are reflected in our income-oriented portfolios today:
1. We prefer dividend-paying equities from developed markets: We expect growth in developed economies to strengthen during the remainder of 2015. The U.S. economy, the global growth leader, is moving into a mid-cycle phase, with growth modestly above trend but with price and wage inflation contained. Assuming their central banks maintain aggressive monetary stimulus, Europe and Japan should both narrow their growth gaps relative to the U.S. We have tilted towards European equities as one of our highest conviction investment ideas, given attractive yields, decent valuations and an accommodative European Central Bank. In a customized allocation, we are capturing an average dividend yield approaching 4.5%. We look for a diversified mix of shares that can offer sustainable risk-adjusted income, rather than simply picking the highest yielding names.
2. We maintain a measured exposure to high yield: Despite weakness in some commodity driven sectors, we believe fundamentals in the asset class remain favorable. The Barclays Capital U.S. Corporate High Yield Index yields close to 6% and default rates are expected to be in the 2%-3% range over the remainder of 2015, comfortably below a long-term average of about 4%. These positive fundamentals have led us to maintain a sizeable portfolio weight to high yield, albeit at the lower end of the weights we have historically held.
3. Opportunistic allocations express a positive view of U.S. economy: We continue to seek income from opportunistic allocations such as non-agency mortgages and preferred equities. These exposures are predominantly U.S. focused and offer impressive yields. Non-agency mortgages, which are predominantly residential mortgage securities not insured by governmental agencies, provide low duration sensitivity and no exposure to the energy sector. These attributes have led the allocation to be both additive and diversifying to other portfolio positions. U.S. financials comprise the majority of our preferred equities allocation, offering compelling yields and a higher place in the capital structure than common equities.
4. The U.S. dollar is our preferred currency: Currency volatility has buffeted global markets during the past year. Central bank stimulus in Europe and Japan has led to downward pressure on the euro and yen relative to the U.S. dollar. Higher growth in the U.S. has also supported the USD. As we continue to seek out the best income opportunities globally, we look to manage foreign currency risk by hedging some of this foreign currency exposure.
Traditional sources of income will be hard to come by, even after the Fed is well into its next rate hiking cycle. More than ever, the search for income requires investment flexibility beyond traditional capital structures, asset classes and regions. Investors will be well-served by a dynamic pursuit of yield, with a focus on downside protection and a global multi-asset class opportunity set.
FOR INSTITUTIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION
High Yield: Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk.
Currency: Generally, when the value of the U.S. dollar rises in value relative to a foreign currency, an investment in that country loses value because that currency is worth fewer U.S. dollars. Currency markets generally are not as regulated as securities markets, and currency exchange rates may fluctuate significantly over short periods of time.
Dividends: There is no guarantee that companies will declare, continue to pay or increase dividends.