Over the past decade, extremely accommodative global monetary policy has helped fuel a search for yield that has driven up bond market valuations. However, the multi-decade bond bull market that has been underway since the 1980s might have passed its apex, with yields having risen since mid-2016 amid accelerating global growth.
Despite this, the returns available to fixed income investors are still low by historical standards. Furthermore, the US Federal Reserve (Fed) is set to begin reducing the size of its balance sheet in the coming months, which could put further upward pressure on yields. These dynamics have ensured that the risk-return profiles of many fixed income markets are unfavourable relative to historical standards.
Nevertheless, changes in population demographics and supportive policy from central banks elsewhere in the world should ensure that demand for income-producing assets remains strong. As such, my colleagues and I at Brooks Macdonald are searching for ways to generate income by investing in assets outside fixed income. One way to do this is through alternative investments such as convertible bonds, structured notes, property and infrastructure.
A convertible is a type of bond that can be converted into a predetermined number of the issuing company's shares, usually at the discretion of the holder. Convertibles offer the capital protection and income characteristics of bonds, while also providing upside exposure to potential increases in equity prices. Although they generally provide slightly lower yields than non-convertible bonds offered by the same issuer, the optionality inherent in their structures provides the opportunity for enhanced returns if equity markets perform strongly, allowing them to provide highly asymmetric pay-off profiles.
Despite forthcoming changes in monetary policy having the potential to adversely affect bond markets, there is a good chance equity markets will remain resilient. The Fed will reduce the size of its balance sheet only gradually, with the goal of maintaining financial market stability, which should avoid any undue pressure on equity markets. Meanwhile, the corporate operating backdrop is accommodative.
- Global monetary policy has helped fuel a search for yield.
- Alternative assets offer another option for receiving income.
- Structured notes are another option that depend on the underlying asset.
Although Fed policy changes will have a direct effect on the treasury and mortgage-backed securities markets, corporate bond markets could benefit as the Fed reduces its balance sheet. Fixed income investors might reallocate funds to areas of the market that are less affected.
In certain instances, property yields remain higher than those that can be attained from high-quality bond or equity investments. However, it is uncertain how correlated property returns will be with those of other asset classes, given the declines suffered by the sector during the global financial crisis. There is uncertainty over the medium-term effects of Brexit on UK commercial property and this could weigh on the sector.
Potential changes to the regulation of open-ended property funds are also a cause for concern. Several open-ended property fund managers applied large dilution levies on investors following last year’s referendum in response to high volumes of redemption requests and insufficient liquidity in their underlying investments. As such, I hold a cautious view on commercial property as an asset class, albeit acknowledging that there are still opportunities to gain attractive exposure to higher yielding assets within the sector on a selective basis.