Investing for income in a lower growth world

21 Nov 2012 08:00
By Aymeric Forest
Fund Manager
Schroders Multi Asset Investments

Investors everywhere are looking for income; at the same time, traditional sources of income are drying up. It is time to widen the opportunity set.

Relying on one asset class for income reduces opportunity and carries more risk than in the past
A benchmark-unconstrained multiasset fund has the flexibility to find attractive yield wherever it arises

It is important to focus on quality and risk management to avoid capital erosion and ensure sustainable income

Traditional sources of income are drying up…
The ‘traditional’ way to earn income has been to hold government bonds (issued in your home market) or money market instruments. In this economic environment these no longer provide an answer since they do not provide a yield high enough to satisfy investors’ objectives, either in inflation-adjusted or absolute terms.

Since 2007 government bond yields have dropped to levels unseen since the Great Depression. Governments and central banks across the world are committed to providing the lowest possible cost of refinancing so that the banking system is gradually able to repay debt without causing too much damage to already low economic growth.

Very low interest rates and quantitative easing (where the government prints money to buy assets such as government bonds), combined with risk aversion and the poor outlook for growth, have contributed to the falls in government bond yields.

…in a lower growth world
The excessive borrowing accumulated since the 1990s is likely to continue having an effect on economic growth for several years ahead. Governments are being forced to tighten fiscal policy and reduce spending in order to reduce their debt, while households and banks are also over-borrowed.
Historically economic growth rates have on average been 4 percentage points lower when a country’s debt exceeds 90 per cent of its GDP.

This level of debt, already reached by some developed markets, may soon be reached by more countries.

With slowing economic growth, capital gains from investments will be harder to find – and come at a greater level of risk.

…while demand for income increases
The pressure on public finances is likely to prevent governments from meeting all of their pension promises and the responsibility for generating investment income will increasingly fall on individuals. But with traditional sources of income yielding less, investors are currently unlikely to make up this gap unless they take a new approach to income investing.

Schroders carried out a ‘European Wealth’ study to assess the attitudes and outlook of investors across Europe (taking 1,400 investors into account across nine countries). We found that there is a substantial gap between the level of income in retirement that these investors desire and their likely retirement income. Excluding the UK, the annual shortfalls ranged between €10,000 and almost €23,000 per annum.

Why investors need to consider a multi-asset approach to income
With yields from traditional sources of income falling, and with risk rising, investors need to maximise their opportunities and diversify.

Single asset class risks have increased
Previously, the level of risk was directly related to the yield provided by any particular asset class. In other words, higher-yielding assets carried more risk and lower-yield assets less. However, the current economic background is vulnerable to shocks and any single asset class is likely to suffer from a higher level of systemic risk. This makes diversification more important than ever.

Widen the opportunity set
A multi-asset approach delivers an improved risk/return trade off in comparison to holding each asset class on its own.

It can take advantage of a wider range of income-generating asset classes – not just the traditional government bonds or money market instruments. This includes higher yielding equities, infrastructure, and different types of bonds, such as investment grade and high yield debt, emerging market debt and municipal debt, from all around the world.

… with an unconstrained approach
A benchmark-unconstrained approach means taking advantage of yield opportunities in whichever region or sector they arise – without having to ‘hug’ a given multi-asset benchmark.

It is possible to construct a multi-asset portfolio yielding in excess of 5% – providing that you are unconstrained in terms of asset allocation and use a non market-cap approach to security weighting.
A global and unconstrained framework is required to open more doors to hidden opportunities. Even in low-yielding markets it is possible to find high-yielding securities. By reducing constraints investors can capture income more safely.

… focusing on quality
It is important not to chase the highest yields, but look for income that is sustainable. What matters for investors is not only the promise of a future yield but the associated probability of default on the payment of a coupon or of a dividend cut.

Through a disciplined risk management process
One way of managing risk is to ensure that the portfolio is diversified and not overly-concentrated in companies, industries, currencies, countries or asset classes.

In today’s market, high dividend companies tend to be concentrated in sectors such as telecoms or financials, or in some countries like Australia and the UK.

Sometimes diversification is not enough and you need to be able dynamically to hedge unwanted sources of risk. This can include hedging duration (the risk that interest rates go up) and equity market risk.

The evolution of downside risk management techniques and derivative instruments enables the astute investor to have access to the required income while aiming at a lower level of volatility than is typically the case when investing in a single higher-yielding asset class.

In conclusion
Income investing is not new. What is new are the challenges faced by investors in creating a portfolio with the right level both of income and risk in this low yield, low growth, more uncertain world.
And yet the demand for incomegenerating asset classes and solutions is increasing all the time.

Investors are aware that with low returns from cash in many markets the only chance to achieve their objectives is to take more risk but that this increases the probability of capital erosion. This is why managing risk and avoiding drawdowns is as important as finding income.

We believe that the best strategy to achieve a positive real return and a high income is to combine unconstrained security selection focused on sustainable yield with a strong dynamic risk management focused on diversification and capital preservation.