Now is the time to look at corporate bonds and equities

It was on this day that Mario Draghi, president of the European Central Bank (ECB), announced it had cut its deposit rate to -0.1 per cent.

In other words, the ECB has become the first big central bank to charge banks for parking their money with it.

Now, the reasons for this are clear. The euro area economy is struggling to grow – or, as the International Monetary Fund’s (IMF) recent ‘World Economic Outlook’ document noted, the euro area economy has the greatest risk of a return to recession of any broad economic region in the world.

Negative deposit rates also proved to be the cautious signal that pushed yields in almost all of the euro area’s bond markets sharply lower.

Unless you like the idea of buying Greek sovereign debt, it is hard to generate more than a couple of per cent of annualised yield from the euro area 10-year government bond market. Meanwhile, benchmark German 10-year bonds yield less than 1 per cent.

So, where does the income investor look if cash and sovereign bond yields offer such negligible returns?

Corporate debt sounds like a good idea, as generally the average company has run its balance sheet in a more prudent fashion than the average government in recent years.

Certainly the scope to provide more yield than the sovereign bond markets is apparent, but any attempt to try to generate annualised yields of substantially more than 3 per cent comes at a price of engaging with the non-investment grade corporate debt market.

Yields of so-called ‘junk bonds’ have also sharply compressed over the past couple of years, but a slow-growth-at-best euro area economy is a double-edged sword.

Low or no growth can mean pressure on corporate profitability and cashflows, and generally a junk bond is so rated to reflect a high debt burden. The high level of volatility in the junk bond markets during July is a warning to anyone perceiving they can be the major source of income for portfolios.

Volatility is a natural component of the equity markets, of course, and for this reason, historically, many income-seeking investors have been less willing to have high equity weightings in their portfolios. The cash deposit and bond market yield compressions of recent years means this view needs to be updated.

There are also other sources of income available – for example, property/infrastructure-based investments or derivative-based plays – but these suffer from illiquidity and complexity respectively. Sometimes it is better to keep investments as plain vanilla as possible.

In the hunt for income in Europe today, corporate bonds and equities are the key assets. The key is to have more of the latter than the former. The current volatility in equity markets gives a perfect opportunity to build or augment such a position.

Chris Bailey is European strategist at Raymond James

Income in Europe

Chris Bailey from Raymond James says:

“Today the fear of making equity income the major source of income for portfolios is far too cautious.

“Uncertain economic times inevitably induce volatility in equity markets, but the compensation in terms of equity yield is generally very attractive, with groupings of large capitalisation euro area or pan-European equities offering yields of 4 per cent plus.

“Clearly, tough economic times will make some individual company yields unsustainable but, via a diversification strategy, much of this specific risk can be mitigated.

“The other aspect is – unlike fixed principal bond investments – equity markets also offer medium-term capital growth prospects too. Particularly if, as appears likely, further stimulus from the euro area authorities is forthcoming.”