Fixed IncomeMay 20 2013

The diversified approach to income portfolios

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ByMike Amey

Historically, UK investors have sought sterling income streams in corporate bonds or equity income funds.

In each case, these strategies involve relatively high levels of capital volatility or lower consistency of dividend payment.

For example, the UK corporate bond market has an average maturity of 14 years and a yield of just 3.5 per cent.

Additionally, the prolonged rally in high yield bond markets and the resulting yield and spread compression has challenged investors’ search for consistent and attractive sources of high-quality income.

The Sterling High Yield Bond index currently yields 6 per cent, for example.

For income investors, having the ability to access a broad opportunity set rather than focusing on a single segment of the market can enhance returns and mitigate risk.

Given this backdrop, we take a diversified approach to building our income portfolio by complementing modest high-yield allocations with alternative fixed income sectors.

For instance, we have identified some good opportunities in asset-backed securities which benefit from high credit quality as well as strong yield potential.

We have found that a number of securities within securitised credit, both in the residential mortgage and commercial markets have offered attractive returns for a slight liquidity premium.

In some cases, they offer up to 5 per cent yield for maturities out to 2015 and even if yields rise, we’ll be able to take advantage by reinvesting the proceeds of maturing bonds.

Clearly critical to achieving this return is the individual analysis of each security, both in the quality of the collateral backing the bonds and whether you have first call on those assets in the event that economic conditions deteriorate beyond our stress tests.

As an example, we have taken exposure to senior tranches of select UK residential mortgage-backed securities – known as RMBS – backed by a pool of high-quality, low loan-to-value UK mortgages.

We target senior tranches of these bonds as even in the event that there are losses on the underlying mortgages over and above our stress tests, we retain priority over other bonds in the deal.

Clearly, when investing outside of the more traditional unsecured corporate bond markets or equity income products, the depth of resources and the ability to understand more complex securities is paramount.

For those with sufficient resources, the higher complexity and marginal reduction in liquidity are more than compensated for by the additional yield.

The higher degree of capital security embedded in these asset-backed markets is critical given the long-term challenges still facing the UK economy.