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 $17 trillion 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 multiasset income strategy can still achieve 4 percent to 5 percent yields over a 12-month period. The key to success is in pulling together a judicious mix of income assets across bonds, equities and nontraditional 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 averaged about 10 percent in the 1980s and 6.6 percent in the 1990s, much higher than the average of 2.1 percent 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 debt (in the 1990s), both of which offered very attractive alternatives to US Treasurys. Global high-yield corporate bonds offered a double-digit average yield in the 1990s, while emerging market, dollar-denominated bond yields almost matched those in the 2000s. With these developments, diversifying investment across income assets became a winning strategy.
2021: Primary sources of income
Today, we believe a diversified multiasset 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 toward riskier bonds. We prefer global high-yield corporate bonds; Asian corporate bonds; emerging market, US dollar-denominated government bonds; and emerging market, 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 percent to 5 percent threshold, expected price gains can more than compensate for low yields.
3. Nontraditional income assets: These include real estate investment trusts and 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 nontraditional 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 we acknowledge that a dramatically poorer growth outlook or a major inflation surprise could happen.
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 emerging market bonds, has been more moderate. Only higher-quality (but very low-yielding) bonds, such as investment-grade or Asian, US dollar-denominated corporate bonds, face low drawdowns.
In a nutshell, when you discuss investment allocations with your financial adviser, it is important to first identify your risk tolerance. In the search for income, you can still earn more than the current low yield offered by government bonds, as long as you are psychologically prepared to take on relatively higher levels of risk.
Manpreet Gill is head of FICC strategy at Standard Chartered Wealth Management -- Ed.