According to Dan Kemp, co-head of investment consulting and portfolio management EMEA for Morningstar Investment Management, growing demand for income has been matched by declining yield from traditional income sectors that has meant that the risks within income portfolios have been rising steadily. But, this increase in risk has not been sufficiently understood by managers and is not being picked up by the traditional measures of risk.
Looking first at the reasons for the shift, Kemp, speaking at the Portfolio Adviser Income event, explained that there are three very clear trends evident over the last few years within the income space.
The first of these is the change in demographics. “The developed world and parts of the developing world are getting older. And, as a result of this you are seeing an increasing number of people looking to take assets out; de-cumulation is growing,” he said.
The second is that risk aversion is still very high on the agenda.
“This is a hangover from the technology stock collapse of the early 2000s, helped by the falls of 2008. People are still feeling burned and this has led to a massive rise in risk-targeted portfolios which has pushed up low risk investments.”
The third trend, according to Kemp, is the gradual liberalisation of the pensions industry over the last 20 years, which has promoted a focus on income investing.
These three trends have seen demand for income investments rise sharply, which has pushed prices up and yields down for these instruments at the same time that central bank policy has also weighed on yields.
As an indication of this, Kemp highlights the fact that, while the yield from strategic bonds has fallen 43% over the last five years, more than £20bn has flown into these funds.
Much of this money has come out of gilts, which points immediately to a rise in risk. But, digging even deeper into the high yield bond space, Kemp points out that while the mix between investment grade and high yield bonds within these funds looks to have changed very little over the course of the last five years, there has been a sharp change in the credit quality of some of the investments.
"The number of AAA rated bonds has fallen from around 20% of the mix to very low levels, while the BBB and non-rated bonds are up from 28% to 43% of these funds," he said.
A similar change has happened within the equity income space, the other sector that has seen significant inflows.
At the sector mix there seems to have been little change in the types of stocks these funds are investing in, but, he said, there has been a marked increase from defensive sectors to more cyclical and economically-sensitive sectors.
“There may be incredibly good reasons for this,” Kemp said, but added, “the fact is the underlying credit risk and economic sensitively at the fund level has increased; managers are taking more risk to generate less yield.”
The problem is, while the risk has increased, because market volatility and default rates are so low at the moment, the increase in risk is not being picked up.
Portfolio managers need to be asking themselves, “Are we overreaching for yield at the moment?” he said.
He added: “The other question that needs to be addressed is the illiquidity in these markets; it is the elephant in the room and no one seems to have an answer for how to address it.”
