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Dynamic approach to income investing

This article is part of
Sourcing Income - November 2016

Dynamic approach to income investing

Historically, income-seeking investors have looked no further than the developed market government bond complex to find a reliable income stream. Here, investors would traditionally receive an annual income that ranged between 3 and 5 per cent with a very low risk profile; a safe bet for most investors.

But years of ultra-low interest rates and proactive bond buying by central banks across the developed world have led to a dramatic change in the fixed income universe. This is based on current estimates that around $10trn (£8trn) of developed market government bonds offer negative yields; a neat illustration of the challenges income-seeking investors are facing.

Simultaneously, the ageing population and a change in social security systems continue to accelerate the global demand for income. So what is the next chapter in the global search for yield?

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The most obvious side-effect of the global search for yield has been the hunt for government bond substitutes. Asset classes that have benefited most under this trend include investment-grade bonds, high-yield bonds, emerging market bonds, property and real estate investment trusts, and bond-proxy like equities.

The caveat though is that investors have had to accept higher risk levels for the same, or similar, amount of income. 

This year these search-for-yield beneficiaries have posted positive returns at one point or another. Yet their respective risk-reward profiles show that they have reached either outright unattractive or stretched levels at least.

A 10-year multi-asset forecast demonstrates how no asset class offers a standout risk-return profile at this point in the cycle. The average annualised forecast return over the next decade ranges between -1.3 and 4.2 per cent for the fixed income complex, and only marginally higher at 5.6 per cent for some parts of the equities universe.

If we dig deeper, a rather different set of fundamentals for these asset classes starts to emerge. As an example, investment-grade bonds currently offer a particularly unattractive risk-reward profile for an income-seeking investor: just recently, European companies Sanofi and Henkel issued corporate bonds at negative yields.

Similarly, though offering much higher levels of income, high-yield bonds have benefited significantly from the crowding out effect of central bank bond buying.

The caveat of these fixed income assets is that with spreads not far off their tightest levels, at around 403 basis points (bps) – based on credit default spread index levels – they do not offer a great margin of safety either. Even though these riskier assets have been offering comparatively higher yields of late, investors should still be asking themselves whether a 4.2 per cent annualised return profile adequately compensates for the underlying risk profile of the asset class. 

Considering these fundamentals, the burning question for investors is where should they be looking for income? Not only do investors have to consider whether remaining high income asset classes such as high-yield bonds are still an attractive investment proposition, they also have to consider the potential path of government bond yield normalisation.