Over the last decade, low bond yields and major central banks’ zero interest rate policy have been rough for investors looking for income.
When the Fed cut its policy rate effectively to zero in 2008, we saw a ‘race for income’ kick-off. In our view, this race remains far from over. Today, about USD 17tn of the world’s bond markets offer a negative bond yield. Are income investors condemned to accepting ever lower yields?
The answer is no! In our view, investors who follow a multi-asset income strategy can still achieve 4-5% yield over a 12-month period. The key to success is in pulling together a judicious mix of income assets across bonds, equities and non-traditional income assets, and carefully assessing where to take on more risk, based on individual appetite.
A short history of yields
Looking back over the past decades, yields were not always as low as they have been in the recent past. The 10-year US Treasury yield offered an average yield of about 10% in the 1980s and 6.6% in the 1990s, much higher than the average of 2.1% in the past decade.
However, this seemingly gloomy picture ignores the development of many additional sources of income. For example, new areas of bond markets have matured in recent decades, such as high yield corporate bonds (in the 1980s) and Emerging Market (EM) debt (in the 1990s), both of which offered very attractive alternatives to US Treasuries. Global high-yield corporate bonds offered a double-digit average yield in the 1990s, while EM Dollar-denominated bond yields almost matched those in the 2000’s. With these developments, diversifying investment across income assets became a winning strategy.
2021: Primary sources of income
Today, we believe a diversified multi-asset income generation strategy can generate income from three main sources:
1. Bonds: These have traditionally been the mainstay of an investor’s income basket. However, with today’s low Treasury and Investment Grade corporate bond yields, we believe there is merit in tilting towards riskier bonds. We prefer global high yield corporate bonds, Asian corporate bonds, EM USD-denominated government bonds and EM local currency bonds
2. Equity: Dividend yields from equity investments also play a strong role in an income basket, in our view. While the yield on equity investments remains somewhat below our 4-5% threshold, expected price gains can more than compensate for low yields
3. ‘Non-traditional’ income assets: These include Real Estate Investment Trusts (REITs) or strategies based on selling volatility to generate income.
The improving economic outlook for 2021 justifies increasing exposure to a basket of income assets. In particular, a scenario of improving growth and subdued inflation has historically been positive for riskier income assets, including high dividend equities, corporate bonds and non-traditional income assets.
How much risk should you take?
If you want more income, taking on more risk is inevitable. This involves accepting higher volatility, keeping in mind your individual risk appetite, but there are ways to manage this.
First, be careful about choosing from the riskier income asset classes. We outline our choices in the three main sources of income above, but acknowledge a dramatically poorer growth outlook or a major inflation surprise are risks to our views.
Second, be prepared for volatility. Historical data shows the riskiest income assets, like high dividend paying equities and REITs, tend to face large drawdowns during bouts of volatility. In comparison, volatility in risky bonds, such as high yield or EM bonds, has been more moderate. Only higher quality (but very low-yielding) bonds, such as Investment Grade or Asia USD-denominated corporate bonds, face low drawdowns.
In a nutshell, when you discuss investment allocations with your financial advisor, it is important to first identify your risk tolerance. In the search for income, you can still earn a higher income than the current low yield offered by government bonds, as long as you are psychologically prepared to take on relatively higher level of risk.
(Manpreet Gill is Head of FICC Strategy at Standard Chartered Wealth Management)