Central BanksJan 17 2018

Where to scour the world for yield

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Where to scour the world for yield

For the last eight years, central bankers have cut interest rates, engaged in quantitative easing and in some cases taken rates negative as they have sought to squeeze inflation into the global economy. 

Because central bankers have used government bonds as a policy tool for reflation, this has challenged a major source of traditional income, as these bonds yield virtually nothing and have grown increasingly expensive.

Diversification

It is no surprise that valuations today are looking stretched in some parts of the market. In order to continue to find income, investors will need a greater emphasis on diversification with more attention to risk management.

There are some dangers in over-reaching for yield, particularly at this point in the market and economic cycle. Investors whose primary goal is to achieve income need to still consider the risk they are taking to get that yield as well as the capital return they are generating.

Now is not the time to be maximising risk in the hopes the bull market continues. Instead, the focus should be on producing regular income with a flexible, globally diversified approach and on maintaining the potential to deliver total return.

It continues to be a positive landscape for the global economy and risk assets, and an environment of gradually rising rates, but it pays to be watchful for signs of exuberance and crowding. The late cycle environment favours broad exposure to equities over traditional fixed income. At the headline level, our level of risk appetite remains roughly the same as it was for much of 2017.

As income investors, equities with the ability to grow their income stream are particularly in focus. Dividend-yielding equities with the potential to provide capital appreciation as well as grow their dividend stream through time look attractive.

European equities also offer a diversified stock selection opportunity. Some managers are trimming their exposure to global equities slightly where more capital is being returned via buybacks rather than dividends. 

The outlook for emerging market equities is constructive and they increasingly merit more of a place in balanced portfolios. It is important globally across equities to seek out investments that offer value and the potential for compelling income.

The ability to be flexible, tactical and nimble in finding income has been very important in the low-yield environment. 

An interesting example of a non-core source of income, as part of a broadly diversified portfolio, has been US non-agency mortgages. This allocation provides a compelling and less correlated income stream to the broader portfolio.

Key points

  • Valuations today are looking stretched in some parts of the market
  • European equities could offer a diversified stock selection opportunity
  • High-yield debt is looking slightly less compelling as value in the asset class has been eroded

Preferred equities

Another attractive asset class is preferred equities, which sit in the middle of the capital structure between equities and bonds. They pay a dividend and are typically issued by US banking institutions. Using extensive security selection analysis, you can find attractively high yields and to manage duration exposure in this allocation.

High-yield debt is looking slightly less compelling as value in the asset class has been somewhat eroded, but it remains a relatively attractive source of income. At these valuations, investors are likely to get their coupons but not much in terms of capital gains.

How multi-asset income investors manage interest rate risk in the year ahead will be pivotal, considering the central bank transition underway from easing to tightening.  

The fair value range of US 10-year yields could rise toward the 2.75 per cent to 3 per cent range by the end of 2018 as the Fed funds rate is hiked towards 2 per cent; this would imply a modest flattening from current levels, but not the fully flat or inverted curve that some fear.

For bond yields to move more aggressively we would need either a positive growth shock – implausible when the economy is already growing above trend, a hawkish policy surprise – unlikely at least in the first half as the new Fed chair takes the reins, or an inflation surprise – possible, but a limited risk given the structural pressure on wages from globalisation and technology. 

As a result, yields should continue to merely grind higher as we enter 2018.

Across the major global central banks, the direction of travel for monetary policy is now largely synchronised, even if the timing of policy changes remains rather divergent. Against this backdrop we expect global yields to move broadly in line with US yields.

Interest rate risk

If interest rates gradually start to move up because the market is becoming comfortable with improving global growth and the dissipation of deflation scares we have had in the last few years, that is a positive for risk assets and bodes well for portfolios with some cyclicality. 

It remains important to manage interest rate risk through hedging. Many have been focused on the duration – or interest rate sensitivity – of the fixed income portion of their portfolio.

With interest rates on a gradual but inevitably rising path, having the flexibility to scour the world for yield across different income sources is more crucial than ever.  

Talib Sheikh is portfolio manager of JPM Multi-Asset Income Fund