InvestmentsMar 21 2023

Income asset allocation in a world of higher interest rates

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Income asset allocation in a world of higher interest rates

The traditional asset allocation approach for clients is predicated on the idea that bonds and equities move inversely to each other, and that bonds are owned for income-generating reasons while equities are predominantly owned for reasons of capital gains. 

But the decade following the financial crisis usurped this notion, as bond buying by central banks sent the prices of fixed income assets much higher, and so yields lower, meaning the case for bonds as a source of income dried up.

At the same time, many of the traditional income-paying equity sectors performed relatively poorly compared with non-income paying equities, meaning a relatively narrow part of equity markets was delivering the capital appreciation. 

Investors therefore faced the choice between buying the equities that can pay a dividend – and then being forced to explain to clients why they own the underperforming parts of the equity market – or else own the assets that do not pay an attractive level of income. 

After a decade and a half, core bonds are back on par with equities, offering yields that are comparable or higher than stocks.Eric Bernbaum, JPMorgan

Alex Hardy, a multi-asset investor at Momentum Global Asset Management, says the UK stock market underperformed relative to the rest of the world for a long time due to many investors choosing to buy the non-yielding technology stocks in the US rather than the income payers in the UK.

Michael Walsh, a multi-asset investor at T Rowe Price, says this determination to square a circle that may not have been capable of being squared led to “some equity income portfolios putting 25 per cent of the capital into tech stocks in the name of diversification”.

But Hardy says that as interest rates and inflation have risen – and are unlikely to return to the previously record low levels – it is likely that the case for UK equities over the longer term will be stronger than it was during the era of quantitative easing. 

Guillaume Paillat, multi-asset investor at Aviva Investors, says the key to equity exposure that combines income and capital growth potential is “not to be too fixated on whether a fund is an ‘equity income fund’ or just an equity fund that has some stocks that pay dividends, and to be relaxed about including the latter even in an income portfolio”.

Split decision

David Coombs, head of multi-asset funds at Rathbones Unit Trust Management, says: “When bonds were falling in price, that was creating a capital loss on portfolios, and one almost had to own growth equities to mitigate that capital loss, but this year as bond prices have recovered somewhat there has been a bit less need to own the growth equities.

"In terms of the bonds we are owning now, we are sticking with short-duration bonds; you can get 4-5 per cent on some of those and the capacity for capital reduction is much reduced, which gives you more flexibility in terms of the equities you may want to own.”

Eric Bernbaum, who runs the JPMorgan Multi-Asset Income fund, says: “Despite 2022 providing a painful reset for markets, this has undoubtedly created value for multi-asset investors.

"The tremendous repricing of fixed income markets during 2022 has two important consequences for multi-asset income investors.

"Firstly, it brings back the potential for portfolio diversification that was missed last year. With higher yield levels on offer, a drop of 100 [basis points] on the 10-year US Treasury yield would result in a total return of 12 per cent.

"This means bonds can potentially provide more buffer in a market correction or an economic downturn.

"Secondly, income is back in fixed income. After a decade and a half, core bonds are back on par with equities, offering yields that are comparable or higher than stocks.

"At over 5 per cent, corporate bond yields exceed the earnings yield of equities while extended fixed income markets such as US high yield offer all in yields well above those of stocks.”

Bonds being relevant again for income investors is also on the mind of Fahad Hassan, chief investment officer at Albemarle Street Partners. 

He says: “Asset allocation in income portfolios can rely more heavily on fixed income assets in 2023. A declining inflation and yield backdrop helps limit the volatility of owning fixed income assets, at a time when yields are higher than average.

"These holdings should also provide greater stability to portfolios if economic growth weakens more than expected. We favour high-quality government and corporate bonds but see value in high-yield debt as well.”

Coombs says he is also not keen on owning cash in portfolios right now as an asset allocation decision, as he says that in the current inflationary climate, holding cash as the result of an asset allocation decision is highly risky. 

Walsh says another option for investors seeking to have an income portfolio that does not sacrifice too much growth is to buy some growth assets and “sell” some of the upside. This is known as 'sell options'. 

Essentially, investors receive a payment now, which they can use to fund income payments to clients, in exchange for which a certain proportion of the future capital gain of the equity goes to the person who made the payment.

James Klempster, multi-asset investor at Liontrust, says that while there is much focus on being geographically diversified, “in reality, this is the same as being exposed to different investment styles, and that is what matters”. 

David.Thorpe@ft.com