The financial crisis has led to a decline in nominal long-term interest rates. UK Gilts, other major government bond markets and cash rates now earn less than inflation.
This creates a significant problem for income-seeking investors. With most income portfolios traditionally relying on these asset classes as an essential source of yield, and government policy measures deliberately seeking to ensure interest rates remain low in order to reduce the debt burden, previously reliable sources of income are unlikely to be meaningfully revived for some time in our opinion.
In a low-growth environment which is likely to persist for some time, we believe that investors should consider a multi-asset approach to sourcing income. As explained here, building a portfolio around three pillars – equity income, high yield credit, and emerging market debt (EMD) results in a very broad opportunity-set, providing income investors with diversified sources of yield. In particular, it gives the fund manager the flexibility and choice to over- and under-weight allocations as the environment changes with the aim of ensuring a high-quality, sustainable income flow.
Equity income:
There are several advantages to including quality dividend-paying stocks in an income-centric portfolio. The case for quality dividend-paying stocks can be made on two counts. Firstly, the underlying macroeconomic environment is one that has traditionally seen this set of equities perform better relative to the overall market. Secondly, companies with an established dividend history are in a good position to grow dividends, as balance sheets have improved significantly since the financial crisis.
A diversified exposure to equity income via dividend streams should also provide a form of inflation protection. Over the medium term, successful firms will have a certain amount of pricing power that will be exerted, as underlying costs are passed on to end-consumers. This ability to maintain an edge over inflationary pressures directly feeds through into earnings. And while dividend payments are not linearly related to earnings, earnings growth is a determining driver of dividend growth over the longer term.
And while income-centric portfolios necessarily focus on yield return, high yielding stocks have historically outperformed with dividends constituting an important part of total investor return. Put simply, yield has proved a simple but effective tool for selecting outperforming stocks.
High Yield income:
The headline attraction for including high yield (HY) corporate debt in an income-seeking portfolio is clearly the favourable yield of the asset class. Given the expanse of the HY universe, there is plenty of opportunity to create a well-diversified HY basket, yet achieve high aggregate yields. Indeed, while individual assets within the class may have material company-specific risk, these can be mitigated, but more importantly, diversified away in an appropriately constructed basket.
Another positive aspect of HY is the nature of its relationship to other fixed income asset classes. In a structural environment that is unlikely to favour assets with a significant relationship to interest rates, it might appear as if all fixed income asset classes would be disadvantaged. However, this is not the case. Whilst historically correlations between corporate debt in aggregate (HY and investment grade) and government debt has been high, correlations between just HY and government debt have been zero or negative depending on the time period. These figures underline the point that HY is very much a set of assets dominated by credit considerations, rather than interest rates. In this respect, value in HY can be thought of as primarily a function of the health of corporate balance sheets, given the macroeconomic environment.
