Should advisers be looking for alternative yield sources?

Sandro Pierri, chief executive officer at Pioneer Investments, explains: “The prolonged low interest-rate environment is magnifying the need for returns. The so-called safe government bonds at the current yield levels are just not luring investors.”

Securitised credit and asset-backed securities

Since the onset of the financial crisis back in 2008, the securitised credit market has been gaining traction and, according to data analytics provider eVestment, to the end of 2012 the broad securitised credit universe outperformed the S&P 500 index by 80 per cent.

Research vice president at the firm, Peter Laurelli, adds: “In the past two years [to the end of 2012] the numbers are similar, securitised credit funds outperformed the S&P by 70 per cent.”

Similarly, in spite of its reputation suffering significant damage during the financial crisis, 2012 saw the asset backed securities bounce back.

Laurence Kubli, portfolio manager of the JB ABS fund at Swiss & Global Asset Management, says: “2012 witnessed a strong rally in European ABS as investor demand increased, recognising the strong credit characteristics and the significantly enhanced relative value compared to some senior unsecured financials and covered bonds.

“The European ABS market is a large diversified market which covers a range of individual risk profiles. Performance during and since the credit crunch has been outstanding with only 1.11 per cent of European ABS experiencing defaults between mid-2007 and mid-2012, compared with 14.84 per cent in the USA.

“In spite of this, rating agencies subject new issues to even greater scrutiny than ever before.”

Simon Callow, fund manager of the CF Miton Diversified Growth fund, invested in a listed fund launched by TwentyFour Asset Management earlier this year, which he says provides exposure to the “high yielding, but defensive” ABS market.

“The securities are incredibly robust, but are often overlooked by investors. Default rates have been exceptionally low within the asset class, yet annual returns as high as 10 per cent should be achievable,” he says.

The TwentyFour Income fund targets less liquid, higher yielding asset backed securities and looks to generate a net total return of between 7 per cent and 10 per cent by investing in the lower-rated, less liquid tranches of European Asset Backed Securities (ABS). The fund’s dividend target is 5 per cent in the first financial year and then 6 per cent a year thereafter.

Ben Hayward, partner and portfolio manager at TwentyFour Asset Management, explains: “Unconventional policy measures have stripped the yield from many investment sectors, including fixed income and this scenario is unlikely to change for a number of years.

“European ABS is one of the few remaining areas that offer the potential for attractive risk-adjusted returns. An additional benefit is that as these securities are floating rate, they also give investors further upside if interest rates rise.”

In February this year Psigma Investment Management’s Thomas Becket also invested in the TwentyFour Income fund as a way to gain exposure to the residential mortgage backed securities market.

He says: “There are precious few exciting yield opportunities remaining in fixed interest markets and we believe that this is as compelling an investment opportunity as we can find across global markets.

“The bonds that the managers buy also have floating rate coupons, which can move higher to reflect changes in Libor. When interest rates start to rise from current historically low levels it will be positive for RMBS and ABS.

“This is particularly attractive given the paltry yield and lack of inflation protection offered by government bonds, investment grade corporate credit and (most recently) high yield credit.

“We strongly believe that it is vital for investors to start thinking about a rising interest rate/inflationary environment now, while pockets of attractive ‘inflation insurance’ remain.”

Convertibles

Another area that advisers should perhaps take a closer look at is that of convertibles. JPMorgan Asset Management recently launched a closed-end fund in this space, raising £136m through a share issue.

Simon Miller, chairman of JPMorgan Global Convertibles Income fund. “A wide range of investors is still looking for alternative sources of income in a world of low interest rates, and can see the benefits of obtaining this through a closed-ended company focused on convertibles, an asset class that we believe is under-represented in investors’ portfolios.”

Convertibles tend to have relatively short terms to maturity - usually between three and five years -and this reduces the sensitivity of the asset class to potential increases in interest rates in comparison to other corporate bonds.

In addition, the value of the call option embedded within convertibles increases as interest rates rise, therefore mitigating the negative effect of higher rates.

Leonard Vinville, manager of the M&G Global Convertibles fund, says: “If interest rates begin to rise because economic growth is seen as improving, this is likely to be positive for equity and convertible prices over the medium to long term, in spite of a possible short-term correction if stimulus measures were seen as being withdrawn.

“Convertibles are a hybrid asset class, sharing some of the characteristics of equities and bonds, able to participate in equity movements while retaining the fixed interest value of a bond. Since credit spreads did not widen significantly in recent weeks, the bond floors of convertibles proved resilient,” he adds.

There are still good opportunities for investors in the fixed income asset class, in spite of the compressed yields seen in the more traditional bonds. However, allocating to these more niche areas of fixed income comes with added risk so may not suit every income hungry client.