InvestmentsFeb 15 2017

Desperately seeking yield

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Desperately seeking yield

Traditionally, qualitative bonds, such as government bonds and investment grade corporate bonds, have been viewed as safe and reliable bets for generating income.

However, fixed income is not the anchor for portfolios it once used to be as dwindling inflation levels in tandem with programmes of quantitative easing carried out by central banks worldwide have driven down yields in the high grade bond market.

In the past three years the UK 10-year bond yield has plummeted from a peak of 3.07 per cent in 22 December 2013 to around 1.31 per cent as at 7 February this year. The dip is more significant over a 10-year horizon to 1 January 2017 – from 4.98 per cent to 1.42 per cent.

In fact, some UK government debt has turned negative. At the time of writing, gilts maturing in 2019 and 2020 were yielding minus 0.03 per cent respectively.

A school of thought argues that lowly government bond yields and low interest rates are likely to persist in the near future.

This has, in turn, forced many investors to select riskier assets in order to chase dividends to help to foot living expenses, for example.

A vast proportion of yield-chasing investors have turned to the alternative asset class for the same or similar levels of income they have become accustomed to – albeit at a heightened risk.

Jason Broomer, head of investment at investment research and consultancy firm Square Mile, said: “Alternatives to bonds have been richly valuable.

Many investors are saying: "How else am I going to get a return with bond yields being as low as they are." Alternatives come in different forms but most of them will have hedging inside them to moderate market risk.”

The firm, which offers a managed portfolio service to authorised advisory practices, shed its entire gilt positions in September this year due to dwindling yields, according to Mr Broomer.

He said: “We are looking for returns that are fairly low risk but are uncorrelated to moves in the government bond market. At the moment, we have a larger cash position than we would have liked because cash is yielding next to nothing.

“We have started to look at commodity funds which can be extremely volatile. You can reduce the risk if they are blended within a wider portfolio. We have not made any moves in this area but this is something that we are considering.”

 

Alternatives

The alternative investment industry, which includes private equity, commodities, and real estate assets, is expected to grow fivefold to at least $13.6 trillion (£10.81 trillion) by 2020, according to PwC.

In July, Jupiter created a new position of head of investments, alternatives, in response to the burgeoning market.

The role is occupied by Magnus Spence, the former Dalton Strategic Partnership chief executive, who argued that not all alternative strategies represent a heightened risk compared to convention investment mechanisms.

He said: “There has been without a doubt an increase in demand for liquid alternative strategies over the past six years and it has been largely brought about by wholesale investors who are reducing exposure to bonds and equities.”

He added: “Alternative Ucits tend to have less volatility and risk than equities and some bonds. As a result, many investors are finding it hard to find investments that satisfy their attitude to risk.

“So an investor with a risk profile of say between six and seven per cent can only choose from investments with a risk profile of between four and five per cent.”

“I think investment managers recognise that expected returns need to come down because returns generated from the traditional asset classes are likely to be lower in the future than it has been in the past. It is better to lower expected returns than it is to increase risk and volatility.”

 

Reits

As an alternative to moving up the risk ladder to combat falling government bond yields, investors have also been seeking high-yield bonds, emerging market bonds and, not least, real estate investment trusts (Reits).

The latter has historically been a strong performer. The MSCI World Real Estate Index which consists of large and mid-cap equity across 23 developed market countries has returned just over 65 per cent over a decade to 3 February 2017.

Reits present a different type of risk: liquidity risk. “This was clearly demonstrated as recently as the summer months following the Brexit vote,” Laith Khalaf, senior analyst at Hargreaves Lansdown said.

“Many investors were simply unable to withdraw their investments from these funds because many of them were suspended from trading.”

He added: “There are not many options that are that palatable for income seekers. The stock market looks like the most attractive asset at they moment if they can stomach the risk.”

However, the equity markets also present significant challenges to income-seeking investors. Valuations of developed-market stocks are high. Shiller price-to-earnings ratio for the S&P 500 has been on the increase from 14.87 in 1 January 2012 to an estimated 25.73 as at 6 February 2017.

“The risk with equities is not knowing if they [equity markets] have peaked,” Kim Lerche-Thomsen, chief executive officer and founder of Primetime Retirement said.

“The FTSE 100 has toyed with 7,000 for a while now but we all know that the past is not is not necessarily a guide to the future.

“History shows us that there is a major shock in the stock market every six or seven years. We have not had a major shock for a while so you could argue that we are due one. Investors cannot avoid risk but they can spread it through diversification.”

He added: “I do believe equity markets are overvalued personally because a lot of yield-hungry investors are investing in equities even though it might not be suitable to them. Equities face tough times ahead with Brexit, Trump as president and other political issues.”

Fund manager are also getting more creative in a drive towards greater yield.

For example, among the asset classes Kames Capital’s Diversified Income fund favours is aircraft leasing which allows airlines to expand their fleet without purchasing a plane outright.

Once the lease matures, the leasing company could sale the airplane outright – although the value of the vehicle could depreciate drastically over time.

Speaking to Financial Adviser in November last year, Vincent McEntegart, who manages the fund which targets 5 per cent monthly income, said that the asset could generate yields as high as 8 per cent.

He said the risk associated with such investment is offset somewhat through investment in a mixture of holdings with an income target that sits underneath or above 5 per cent.

Mr Khalaf said: “Some fund managers have been pushed out of their comfort zone and forced to look outside traditional diversification of government bonds. Gold, for example, is not a tradition investment for income but they have risen in popularity particularly because of the low interest rates. However, history shows that the price of gold falls sharply once the market gets a whiff of the potential of a rate rise.”

Myron Jobson is a features writer at Financial Adviser 

 

Key points

Lowly gilt yields have forced many investors to select riskier assets in order to chase dividends.

Investors have sought to substitute government bonds with high-yield bonds, emerging market bonds and real estate investment trusts.

Some fund managers pushed “out of their comfort zone” and forced to look outside traditional diversification of government bonds.