How to construct a portfolio for yield

According to Chris Leyland, deputy chief investment officer for True Potential, it is important to “have a broad spread of income sources” in a portfolio.

He says: “If just one investment fails to deliver its promised income payment, the shortfall has to be made up from elsewhere or the overall fund yield will fall.

“By incorporating many different investments in our models, we lessen the dependency on any one source.”

Chris Iggo, chief executive of fixed income at AXA Investment Managers, comments: “Diversification across sources of yield is crucial to generating long-term income, and this should be achieved at both the asset class and sub-asset class level.”

According to Mr Iggo, a well diversified bond portfolio may typically have 100 to 120 individual holdings with exposure to parts of the market that are offering the most attractive risk/return profile.

One of our investment partners started hedging out currency risk across our monthly income global income fund. Chris Leyland

He says: “At present, we see particular diversification opportunities in emerging market debt, high yield, and financial corporates.”

Darius McDermott, managing director of Chelsea Financial Services, comments: “A diverse stream of income means that you aren't reliant on one asset class providing the yield and, as it ebbs and flows, the balance remains.”

Types of income

Stephen Crewe, director of Fulcrum Asset Management, believes generating even a 4 per cent income from a portfolio has “required an increasingly risky investment strategy".

“Currently, the expected risk entailed in a 4 per cent income has not been detrimental” but he warns this could increase the potential for a shock. Therefore, it is important to de-risk portfolios, especially for clients approaching retirement.

According to Mr Leyland, proper income diversification means increasing the “opportunity set” for capturing yield for investors while spreading and therefore lessening, the risk.

To do this, he said it is important to use specialist bond managers who can target “corporate self-help situations where spreads against government bonds are wide and then narrow as balance sheets are repaired.”

Where can yield come from?

• Government bonds.
• Overseas government bonds.
• Corporate debt/investment grade debt.
• T1 or T2 bank bonds.
• Overseas corporate/investment grade debt.
• UK high yield.
• Overseas high yield.
• Special situations.
• Equity dividends.
• Property income.
• Short-duration bonds.
• Inflation-linked bonds.
• Social impact bonds.
• Cash/money market funds.

Diversification across different types of fixed income and different geography is therefore key, according to Dan Ivascyn and Alfred Murata, managers of the Pimco Income fund.

Mr Murata comments: “A multi-sector approach provides the ability to seek out the best income-generating ideas in any market climate, targeting multiple sources of income from a global opportunity set.

“We diversify across multiple measures: across different regions, various credit sectors, and along the risk spectrum as appropriate with the fund’s objectives. We also balance our exposures.

“We are careful not to let portfolio volatility and returns be dominated by a single risk position.”

Eugene Philalithis, portfolio manager for the Fidelity Multi-Asset Income fund, is adamant that while asset class correlations have risen in recent years, the lower volatility of fixed income means “there is still value” in holding it.

However, he adds: “It is important to diversify into areas such as contingent convertibles (CoCos), which offer yield in excess of 5 per cent.

“These can help balance lower-yielding asset classes, which investors might still want to hold for their defensive properties (such as US treasuries). 

“This is one example of the barbell strategy we have been adopting this year, balancing defensive but lower-yielding markets with higher yielding opportunities, where our research is supportive for this outlook.”

Advisers considering this strategy however might want to outsource to a multi-asset or fixed income fund that invests cautiously and with proper research in CoCos, as the FCA has not really softened its stance on the retail market’s access to such investments.

In 2014, the City watchdog issued a note that it had restricted the distribution of CoCos to retail investors for a year, as these hybrid structures were considered to be too complicated for the average retail investor.

Indeed, in June this year, there was a complete writedown of such bonds at Spanish lender Banco Popular, when €1.25bn of its Additional Tier 1 bonds fell drastically, ending up trading at about half of face value.

This was, according to sister title the Financial Times, before the bank’s resolution and takeover by rival Santander was announced on the morning of 7 June. 

Hedging

Currency risk – as seen with the severe depreciation of sterling against the euro and the US dollar after the UK’s vote to leave the European Union last June – can cause problems for UK investors. 

It can certainly pose problems for bond holders and for those portions of a clients’ portfolio where investors hold either a foreign currency bond issued by an overseas entity, or by holding a bond denominated in a currency other than the domestic currency.

By using a currency hedge within a portfolio, an investor can not only be protected from huge swings in currency valuations, but also the hedge itself could provide a return.

According to Mr Leyland: “With our blessing, one of our investment partners started hedging out currency risk across our monthly income global income fund, which is a significant holding in our income models.”

Although the effect of Brexit talk, economic and political shocks at home and abroad have sent currency markets into little frenzies over the past 12 months, the idea of using currency risk hedging in bond portfolios is not new.

In fact, in a 2014 research note from the US arm of fund manager Vanguard, The buck stops here: Understanding the ‘hedge return’: The impact of currency hedging in foreign bonds, writers Charles Thomas, CFA and Paul M. Bosse summarised this as a means of risk management and providing an alternative income stream.

But while there can be volatility and uncertainty, Mr Ivascyn for Pimco believes it is important for advisers not to see volatility in fixed income markets as all bad.

He explains: “Volatility can also present opportunities, because markets often overshoot or overreact. 

“For example, although we have been cautious in our emerging market positioning in the Income Strategy, we have found some interesting opportunities when investors have been too pessimistic, and yields have widened.

“For instance, the strategy has benefited from select exposures to high quality, quasi-sovereign securities in emerging markets such as Russia.”

simoney.kyriakou@ft.com