Multi-assetFeb 25 2013

Looking beyond traditional sources of income

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The financial crisis has led to a decline in nominal long-term interest rates. UK Gilts, other major government bond markets and cash rates now earn less than inflation.

This creates a significant problem for income-seeking investors. With most income portfolios traditionally relying on these asset classes as an essential source of yield, and government policy measures deliberately seeking to ensure interest rates remain low in order to reduce the debt burden, previously reliable sources of income are unlikely to be meaningfully revived for some time in our opinion.

In a low-growth environment which is likely to persist for some time, we believe that investors should consider a multi-asset approach to sourcing income. As explained here, building a portfolio around three pillars – equity income, high yield credit, and emerging market debt (EMD) results in a very broad opportunity-set, providing income investors with diversified sources of yield. In particular, it gives the fund manager the flexibility and choice to over- and under-weight allocations as the environment changes with the aim of ensuring a high-quality, sustainable income flow.

Equity income:

There are several advantages to including quality dividend-paying stocks in an income-centric portfolio. The case for quality dividend-paying stocks can be made on two counts. Firstly, the underlying macroeconomic environment is one that has traditionally seen this set of equities perform better relative to the overall market. Secondly, companies with an established dividend history are in a good position to grow dividends, as balance sheets have improved significantly since the financial crisis.

A diversified exposure to equity income via dividend streams should also provide a form of inflation protection. Over the medium term, successful firms will have a certain amount of pricing power that will be exerted, as underlying costs are passed on to end-consumers. This ability to maintain an edge over inflationary pressures directly feeds through into earnings. And while dividend payments are not linearly related to earnings, earnings growth is a determining driver of dividend growth over the longer term.

And while income-centric portfolios necessarily focus on yield return, high yielding stocks have historically outperformed with dividends constituting an important part of total investor return. Put simply, yield has proved a simple but effective tool for selecting outperforming stocks.

High Yield income:

The headline attraction for including high yield (HY) corporate debt in an income-seeking portfolio is clearly the favourable yield of the asset class. Given the expanse of the HY universe, there is plenty of opportunity to create a well-diversified HY basket, yet achieve high aggregate yields. Indeed, while individual assets within the class may have material company-specific risk, these can be mitigated, but more importantly, diversified away in an appropriately constructed basket.

Another positive aspect of HY is the nature of its relationship to other fixed income asset classes. In a structural environment that is unlikely to favour assets with a significant relationship to interest rates, it might appear as if all fixed income asset classes would be disadvantaged. However, this is not the case. Whilst historically correlations between corporate debt in aggregate (HY and investment grade) and government debt has been high, correlations between just HY and government debt have been zero or negative depending on the time period. These figures underline the point that HY is very much a set of assets dominated by credit considerations, rather than interest rates. In this respect, value in HY can be thought of as primarily a function of the health of corporate balance sheets, given the macroeconomic environment.

The business climate is clearly of importance in ascertaining to what extent the robustness of any firm’s financial health will be tested. Historically, modestly negative or low positive growth environments have tended to favour exposures to corporate debt. In addition, in all but the very worst recessions, not only is the relative performance of corporate debt far superior to that of equities, but is generally positive too.

Emerging market debt income:

Emerging market debt has traditionally not been included in income-centric portfolios used by UK investors. Part of this relates to the historical under-development of the asset class and, quite simply, there were more familiar income opportunities; there was little need to look further afield.

Today the asset area is supported by the fact that the fiscal positions in emerging markets are far more favourable than many developed economies. They are not suffering under huge debt burdens, have attractive growth levels and are able to offer attractive yields. In addition, many emerging economies are commodity rich and have favourable demographics.

We think that adopting a blended approach to investing in EMD (encompassing local currency, hard currency, and corporate debt) is the optimum way to target income. A blended approach provides investors with exposure to all the main drivers of EM growth and the diversification lowers the overall volatility, and average returns have historically been very attractive

A Multi-asset approach

The three opportunity sets discussed above – established dividend paying equities, high yield corporate bonds and EMD – have their own features that make them attractive as sources of income-intensive returns. We believe that applying adiversified multi-asset approach to thisbroad opportunity set can avoid the tail-risks associated with single asset class approaches.

The ability to adjust nimbly to a volatile investment environment is arguably more important now than ever. And this certainly applies to income-centric investments. With the potential that business cycles could be more frequent and recessionary environments a more persistent risk, the investment architecture to deal with this is not commonly found in income vehicles that previously succeeded in a higher growth world.

The world remains one where income is necessarily a crucial component of most investors’ arsenal – but accessing this necessitates an new approach. A flexible and diversified multi-asset income approach could be a compelling solution.

IMPORTANT INFORMATION

Past performance should not be taken as a guide to future returns. The value of investments can go down as well as up and your clients could end up with less than they invested.

All the information contained in this communication is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This is not a buy, sell or hold recommendation for any particular security.

This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale. The full documentation that should be considered before making an investment, including the Prospectus and Key Investor Information Documents, which set out the fund specific risks, is available from Investec Asset Management.

Telephone calls may be recorded for training and quality assurance purposes.

Issued by Investec Asset Management which is authorised and regulated by the Financial Services Authority, February 2013.

John Stopford is Portfolio Manager of the Investec Diversified Income Fund