how to generate income and sleep soundly

It seems there is a scarcity of asset classes where investors can guarantee a high income and still sleep soundly but, beyond equities, where else should investors look?

how to generate income and sleep soundly


In an unpredictable financial world, retail investors’ priorities have remained remarkably consistent, and income remains top of
the list.

Equities, particularly UK equity income funds, remain popular for good reason, but it has been fixed income asset classes – especially corporate bond and sterling bond funds – that have topped the inflows charts this year.

This tells us two things: that a reliable source of income is sought, and that investors are presently not overly comfortable with risk assets. This makes perfect sense given how volatile equity markets have been this year, and indeed since the beginning of the financial crisis.

Fall from grace

So where should income-hungry investors look to park their money, while still being able to sleep soundly at night?

With government bond yields at record lows (ten-year gilts yield 1.4% at the time of going to press), the popularity of a once reliable income source has taken a tumble.

Indeed, the safe haven status of gilts is now coming under scrutiny. According to recent research from FE Analytics, the asset class has become increasingly risky this year relative to UK equities.

According to its Risk Score criteria, which measures volatility compared to the FTSE 100, the volatility of the IMA UK Index-Linked Gilt sector increased by 10.4%, while that of the IMA UK Gilt sector rose by 8.8% this year (to 11 May). From a longer-term perspective, it says gilts have been more volatile since the financial crisis compared with pre-2008 levels.

For professional investors, volatile markets and the shifting characteristics of different asset classes in terms of risk and yield characteristics, means it is dangerous to be static when dealing across the fixed income spectrum.

Active makes sense

This is one of the reasons why go-anywhere strategic bonds funds have proved so popular, although it is worth noting that returns have been mixed across this sector.

According to FE Analytics, in the year to 26 July, the average fund in the IMA Sterling Strategic Bond fund sector delivered a total return of 6.5%, lagging the 8% delivered by the Sterling Corporate Bond sector and, perhaps surprisingly, 16% for the UK Gilt category.

As George King, head of portfolio strategy at RBC Wealth Management, puts it: “In this environment, active management makes sense.”

He adds: “Trying to implement broad investment themes and generic implementations can be potentially very dangerous in this environment.”

At present, it is high yield, especially US issues, that appears to be attracting much attention.

“The $1trn US high yield market gives an income of 7.5% at present, while the $210bn European high yield market is at around 9%,” says Ece Ugurtas, Barings’ head of credit investing, and manager of its High Yield Bond Fund.

“This entices investors when government bond yields are at 1.5%. These asset classes are naturally attracting a lot of investor appetite.”

Ugurtas has around 80% of her fund in US and emerging market high yield, and, income aside, she highlights two accompanying factors which support the inflows: that companies are in a good shape fundamentally, having reduced the amount of debt on their balance sheets; and that from a valuation perspective, spreads could tighten because the market still has a very negative view on default rates.

She adds: “The default rate at the moment is at 2.5%, which is below the long-term average of 4.5% to 5%. If we look forward, most market participants are expecting defaults to rise to 3% by the end of the year, but if we look at what the market is pricing in currently – a default rate of around 5% to 5.5% – the market has quite a negative view. I do not believe that negative environment will come into play.”

Appeal of the US

William De Vijlder, CIO strategy and partners, at BNP Paribas, tells a similar story. His assessment of yielding assets on a conditional value at risk (CVaR) basis finds that US high yield is an appealing proposition given that it is attractive in terms of yield and its risk/return trade off (see graph below).

“If you look at the full behaviour of the asset class in a recessionary environment, you observe that the cyclical momentum now is weaker in Europe than in the US, and also the forecasts made in that respect are also bleak in Europe compared to the US,”
he adds.

However, not everybody is jumping on the high yield bandwagon. Craig Veysey, head of fixed income at Principal Investment Management, believes that there remains a real danger that in a low growth/low yield environment, investors may stretch to more hazardous areas without fully understanding the risks. He predicts an increase in corporate bond downgrades and defaults.

“If income investors want to sleep well at night, they should remember that high yield is high yield for a reason and there are significant risks attached,” he warns.

“Although I feel more comfortable with the supportive environment of the higher quality end of the corporate bond market, I do not feel quite so comfortable with the high yield area, and when you start getting into BB and C-rated investment grade quality where there is a lot less liquidity. Investors cannot sell out so quickly and this would concern me in an environment of a protracted slowdown, which is an obvious danger in the next 12 to 18 months.”

Emerging potential

Emerging market debt is another asset class drawing inflows from investors attracted to its yield potential. The average yield for hard currency issues is estimated at 5%, while local currency comes out at 6.5%.

For Ugurtas, the appeal is investing in fast growing economies with excellent fundamentals.

“You are buying a better quality asset and you are being paid a higher yield to do so,” she says. “We have appreciating currencies and a much stronger growth profile in these economies.”

Groups, such as Schroders, HSBC and Investec have launched new funds in this asset class in recent months, and more are in the pipeline. Questions therefore have rightly been raised about the consequences of a wall of money flowing into emerging market debt in a short space of time, though De Vijlder dismisses this as an insignificant problem.

“Now is an interesting entry point for emerging market debt, so long as investors enter it on a diversified basis with a specialist asset manager,” he says.

“The position in the asset class is structural and the management of the position has to be active. As the asset owner you need to look beyond these gyrations of money flowing in and out of the asset class with the bounce it can create on the currency as well. The advantages are really structural.”

For long-term investors, De Vijlder also picks out infrastructure as an interesting area from a yield perspective, either through direct investment into a specific sector, such as energy, or more broadly through toll roads or airports. A high degree of gearing – again another risk factor – can also produce an enhanced dividend.

The same applies for commercial property, though fund pickers are keen to point out that it is no longer the one-way trade it was once viewed as where investors can own both real assets and maintain a healthy yield.

Says King: “There is greater awareness that not only are there leverage and liquidity issues, but you might lose money in property funds. This is largely due to the overhang from the credit crisis as mortgages still need to be refinanced, combined with what is happening with rental rates. There is little catalyst for rents to rise, and there are rates set at higher levels in years past that are about to roll off.”

Of course, equities can also offer a gateway to more esoteric income-producing asset classes, though that is a story for another day.


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