Producing yield while reining in risk

Since this time, investors have had difficulty finding income from traditional sources such as cash or fixed income. This is mostly attributable to authorities worldwide using aggressive monetary policy to try to boost their flagging economies.

At first, central bank base rates were slashed close to zero, followed by the introduction of quantitative easing and, in some countries, negative interest rates. 

The collapse in yields was an acceleration of a trend that began in the 1980s as inflation expectations fell. The causes of this are widely considered to include China’s increased participation in world trade, demographic changes in the developed world and inflation targeting by autonomous monetary authorities. 

Falling yields have been both a boost and a challenge to investors. Fixed income investors have benefited from this extended bull market, achieving equity-like returns from assets traditionally considered to be of lower risk. Gilts, investment-grade and high-yield debt have all produced returns over the past 10 years in excess of those achieved by the UK equity market. 

While the benefits from a total return perspective are plain to see, the challenge for income investors is equally clear.

As yields have declined, income investors have either had to accept a lower level of income from their portfolios or raise exposure to traditionally riskier assets (or some combination of the two). Therefore, the challenge in this environment for advisers has been how to achieve acceptable yields for their clients while ensuring that client portfolios maintain an appropriate level of risk.

Risk comes in many guises and is not limited to statistical measures of return volatility. UK commercial property provides a higher yield and the nature of valuing the assets provides a smoothed return profile; however, this masks the illiquid nature of the asset, which can create risk for investors.

Last July brought a salutary reminder of this when many UK commercial property funds suspended trading in the aftermath of the Brexit referendum. 

This year is likely to bring a further complication for income investors. Not only do they have to consider this balance between income and risk, but the latter is complicated by the question of whether the fixed income bull market is at an end.

In an environment where yields rise from such low levels, income-generating assets (including so-called bond proxy equities) may not only lag other assets but could lead to capital loss. Markets issued a stark warning about these dangers in the second half of 2016, as yields rose.

While much of the narrative attributed this rise to Donald Trump’s US election victory, the reality was that yields had started rising in the preceding months. From September to the end of November, broad gilt indices returned falls of more than 7.5 per cent, with long-dated gilt indices reporting double-digit losses. Sector returns within UK equities show a similar story, with bond proxies selling off aggressively. Consumer staples and utilities returned -7.4 per cent and -8.5 per cent, respectively, against a broad market which produced a modest 0.6 per cent return.

Asset Class Performance

When considering these figures, it is important to realise that many income investors have mixed motivations. For some, the need for income may supersede all other concerns. However, many require their investment portfolio to generate income over the long term and these investors now have some difficult decisions to make.

Valuations appear stretched in most areas of fixed income, with the same applicable to US equities. While emerging market debt and equities provide some attraction, the risk tolerance of many income investors will mean exposure to such assets will be restrained. This brings investors with long-term income portfolios to consider a difficult decision – whether to increase their exposure to cash.

While not providing any significant income in the short term, it does provide much-needed capital protection. This could be crucial to investors who want to defend their capital in order to protect their portfolio’s ability to generate income over the long term. 

Richard Whitehall is portfolio manager at Morningstar Investment Management Europe