From Special Report:
Search for Income - February 2013 40min
Alternatives to cash for safe income generation
Keeping money in cash very unappealing, not least because of the very low rates of interest on offer.
We find ourselves in perverse times. Base rates in the UK remain rooted at record low levels, with no sign of a change in stance from the Bank of England. This creates significant problems for those who wish to earn an income on their capital.
First, it makes keeping money in cash very unappealing, not least because of the very low rates of interest on offer. Second, with inflation remaining stubbornly above the Bank of England’s target and significantly above the base rate, the real value of cash is being eroded by around 2 per cent a year – all this from a supposedly risk free asset. Indeed, you would have to go back to the 1970s and 1980s to find such a corrosive environment for holding cash. Finally, and more subtly, a huge variety of asset classes are priced with reference to cash rates, resulting in lower-than-expected returns from almost any asset class you can care to think of.
So where should those who want to generate income turn? The obvious first port of call would be fixed income securities, particularly if investors are divesting out of cash and investing for the first time. Fixed income, as the name implies, offers investors a fixed return from a bond. For some bonds, such as those issued by AAA-rated governments, there is virtually no credit risk. However, the recent downgrading of several sovereigns has reduced the number of top-quality debtors and demonstrated how quickly even sovereign ratings can change.
The drawback of these ultra-safe bonds – which includes those issued by the US, UK and Germany – is that they offer the lowest yields, which may not be enough to meet investors’ income needs. Furthermore, in many places, such as the UK, the yields on offer are often negative when the effect of inflation is factored in. To receive higher yields from fixed income, investors need to invest in bonds that entail greater credit risk. Theoretically, this should increase income and total returns in the long run, but it also increases investors’ risk of losing part of their initial investment. The events of 2008 showed how a concentration in credit can materially impact a portfolio in a crisis. Nonetheless, investors have piled into fixed income over the last few years, with the riskier parts of the market benefiting the most in the so-called ‘stretch for yield’.
Investors can usually also achieve extra income by buying longer-dated bonds, that is, those with more years to maturity. For example, the 10-year UK government bond currently yields around 2 per cent while the 30-year bond yields slightly above 3.2 per cent. However, longer-dated bonds also come with higher duration, which means they fall more in value if yields rise. This is a particularly relevant consideration given that yields are already trading close to record lows, having been falling for approximately 30 years. Moreover, the low level of coupons offers less protection to bond investors’ total returns, and when interest rates normalise, they are likely to be faced with significant capital losses, particularly in longer-dated bonds. This means that anyone investing now expecting to achieve similar levels of return as they have historically is likely to be sorely disappointed.
Equities are also popular with income investors, particularly those with greater risk appetite. The most common way to generate income from investing in equities is to buy stocks with high, stable dividend payments. Typically, shares in these large, high-quality companies that generated significant free cash flow have performed very well over the past few years. The trouble is, this scramble for yield has, in my opinion, led many to over-pay for these characteristics, particularly in Western, developed markets. As a result, valuations of high dividend-paying stocks look quite rich, particularly relative to the broader market.
It is not quite so clear cut in the emerging markets. Here my analysis indicates that exposure to stocks with high “quality” and “dividend” characteristics so favoured in the developed markets is much less overbought in emerging markets. This is likely because investors tend to view emerging markets as a growth play, rather than sources of income.
Stocks offering high-dividend yields are generally concentrated in a small number of industries, such as consumer-related, telecommunications, utilities, energy and – historically at least – financials. So an equity income strategy that consists of simply buying high-yielding stocks will tend to be highly concentrated in certain sectors and thus highly exposed to the risk that these sectors may underperform. In other cases, a high dividend yield may be a sign of potential distress. For example, UK banks, at face value offered a dividend yield of some 8 per cent in August 2008; UK banking stocks then fell by 67 per cent over the six months following Lehman Brothers’ bankruptcy in September 2008.
There is another way to earn equity income. Investors can use ‘call overwriting’, a strategy that involves buying shares (or equity indices) and simultaneously selling call options on those same assets. The investor is effectively paid a premium to give up capital gains above a certain level. This strategy yields higher income than straightforward equity exposure, particularly in periods such as 2009 when investors received very large premiums for writing calls, as the price of optionality benefited from the volatile market environment. However, at the moment, with implied equity volatility close to the lowest level since 2007, the additional premium is not as attractive as in the recent past. Nonetheless, earning income through this technique does counter concerns about buying areas of the market that look quite stretched, such as high-dividend stocks.
Away from fixed income and equities, what other asset classes might investors consider? Real estate is an asset class that income investors should not ignore – UK real estate, for example, has offered consistently higher yields than global equities or bonds over the past decade. Direct ownership of buildings is impractical given the costs, illiquidity and concentration risk of the investment. A popular, although more volatile, alternative is exposure to real estate investment trusts (REITs).
Increasing interest can also be witnessed in other ‘real’ asset classes, such as infrastructure. Here, the attraction to income investors is clear. Infrastructure projects are often in partnership with governments or are in highly regulated industries. Consequently they tend to offer stable rather than spectacular returns – perfect for income investors who want stable capital and relatively predictable levels of income. Importantly, the payments in such infrastructure contracts are often linked to inflation.
One area of the market that has caught my attention recently has been insurance-linked securities. Distinct from the life insurance sector, in my view, there is an attractive premium (cash rates +5 per cent to 6 per cent per annum) that can be captured by offering reinsurance protection against natural and other disasters. With insurance-linked securities, investors receive annual premiums and a measure of capital growth in non-event years, which is drawn on by insurers depending on the magnitude and frequency of catastrophic events.
Another part of the market to be considered is commodities, which, on first sight, might not seem like a great fit with an income objective. After all, there are no cash flows directly associated with owning commodities. However, by applying a call-overwriting strategy (much like with equities), by using the implied volatility of commodity prices, it is possible to generate income by selling away a degree of expected capital growth.
While I have outlined a number of potential alternatives to cash, the key point to advocate is that inertia – leaving your money in cash – is destructive to your wealth. Financial repression looks set to continue and only by staying open-minded, embracing a degree of risk and broadening the scope of an income strategy, can income-focused investors hope to navigate this challenging market environment.
Matt Bance is a strategist, global investment solutions of UBS Global Asset Management
* Low base rates in the UK it makes keeping money in cash very unappealing, not least because of the very low rates of interest on offer.
* The most common way to generate income from investing in equities is to buy stocks with high, stable dividend payments.
* Another part of the market to be considered is commodities, which on first sight might not seem like a great fit with an income objective
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