IN FOCUS6-8 min read

The hunt for income– three things to look for

With interest rates likely to be lower for longer, investors are seeking yield from potentially riskier investments. We analyse alternatives and share three key factors to consider in the hunt for income.

20/02/2020
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Authors

Mihkel Kase
Portfolio Manager, Fixed Income

Record-low interest rates pose a challenge for income-oriented investors. That challenge is particularly acute for those living off the income from cash investments.

While their capital may be stable, ever-lower interest rates have seen their incomes steadily falling. So it’s unsurprising that many are moving away from cash and looking further afield.

Yet shifting from cash to a different asset class involves much more than just switching to a higher-yielding investment. It’s important to take a whole-of-portfolio view as not all risk is the same.

  •  With interest rates likely to be lower for longer, investors are seeking yield from potentially riskier investments.
  • Investors need to understand the investments they are holding, why they are holding them, what risks they are willing to bear in respect of those assets and how they may behave if markets fall.
  • There are three key considerations for investors seeking to change their portfolio allocations to boost income – liquidity, diversification and risk control.
  • The Schroder Absolute Return Income Fund (Managed Fund) (Chi-X code: PAYS) can help investors strengthen the defensive allocation within their portfolios by boosting income while protecting capital. 

Cash investments are highly liquid, highly secure, and can be an effective way to diversify and reduce risk. It follows that there are three key factors investors need to be aware of when considering the alternatives:

Liquidity: Are you prepared to lock your capital up for longer time-frames?

Diversification: Are you putting all your eggs in one basket and potentially missing the opportunity to improve overall investment returns and manage risk?

Market expertise: Do you have the expertise to navigate diverse, global, fixed income markets or would you benefit from tapping into the expertise that specialises in finding income?

Alternatives to consider

SCHRODERS_Yieldonassetshedged

Liquidity

Yes

Yes

Yes

Variable

No

Variable

Store of value

Yes

Mark-to-market risk

Mark-to-market risk

Capital at risk

Impairment possible

Defaults likely

Source: Bloomberg, Schroders as at 31 December 2019. Yields on assets hedged to A$. CBA Pearls XII yield used as a proxy for Hybrid yields. Yield percentages used are for illustrative purposes only and not a guarantee of any particular return. Liquidity profile is indicative only and may vary depending on the particular product.

The graph below shows six investment options available to investors trying to boost income from their investment portfolio. As a generalisation, the further right an investor ventures, the more risk they are taking and the higher their potential to suffer a loss.

In the hunt for yield, investors are looking further to the right – higher on the risk spectrum, and potentially into areas where they may not be familiar with the characteristics of the asset.  Investors must be conscious of factors such as ‘store of value’ which refers to the ability of an asset to be saved, retrieved or exchanged later.

While there are pros and cons to each option, the important thing is for investors to understand what they are holding, why they are holding it and how it will affect their portfolio performance in different market conditions. For example, Australian government bonds and investment grade credit are exposed to factors such as market-to-market risk whereas mortgage funds can be impaired by defaults, which can hamper liquidity.

So let’s return to the three asset allocation issues highlighted above, to see how the alternatives stack up.  

Liquidity

There’s a saying in markets: liquidity is never a problem except when you need it most. If an investor is looking to withdraw money from an investment because they are concerned about near-term risks, it’s likely others will be too, which may mean it will cost more or take longer to exit the position.

This cost increases with the riskiness of the investment. In cases of high market volatility when it’s very costly (or even impossible) to liquidate riskier positions, sometimes redemptions from funds can be frozen.

At other times investors simply need liquidity because plans change. Having cash available provides maximum flexibility to respond at a limited cost (both transactional, and in terms of market timing).

All of these considerations suggest it’s worth keeping at least some capital in a more liquid investment option, perhaps as part of a diversified fixed interest portfolio.

Diversification

Investors have been taught that the more risk they accept, the greater the potential returns. Yet while this is generally true over the long term, there will always be periods where greater risk will detract from returns – as happens when share markets are falling. Given the unpredictability of markets, diversification across asset classes is crucial to delivering more reliable returns.

Diversification is important within asset classes too. Not all investors appreciate that there are many types of fixed income, each of which behave very differently in different market conditions. That can create attractive opportunities for investors, but it also means diversification across fixed income markets can be an essential tool for improving overall returns and managing risk. 

Tapping into fixed income expertise

When moving away from the security of cash, it can make sense to choose an investment with in-built risk controls. Because fixed income markets are diverse, global, and frequently changing, that may mean tapping into the expertise of fixed income specialists – ‘active’ managers, rather than ‘passive’.

One of the peculiarities of fixed income markets is that indices are weighted towards entities with the most debt, which can leave passive investors heavily exposed to lower quality credit, carrying the highest levels of risk. In contrast, actively managed fixed income funds provide access to a team of experts who specialise in finding high quality income opportunities, with the aim of taking advantage of them at the right time in a market cycle, while also focusing on managing risks.

Active managers often focus on valuations, or the price paid for an asset, which can have a significant bearing on the investment return achieved. Put simply: they aim to help investors find ‘winners’ and avoid ‘losers’.

Choosing the right option

Finding the right option isn’t always easy, but it is important. The key is to keep your overall investment objectives in mind, then build a portfolio to match – without taking on too much risk.

Schroders has launched an active fixed income exchange traded fund (ETF): the Schroder Absolute Return Income (Managed Fund) (Chi-X code: PAYS). PAYS is designed to help investors strengthen the defensive allocation within their portfolios by boosting income while protecting capital.

PAYS gives you exposure to the Schroder Absolute Return Income Fund, which has a track record of meeting investors’ needs for reliable monthly income, delivering a total return of 6.13% over the last 12 months (post-fees) with a competitive management fee of 0.54% pa.  

PAYS gives investors the flexibility to access their money if they need to, providing peace of mind that there is a strong focus on managing risk, should markets fall. 

Important information

Important Information:

This document is issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders). It is intended solely for wholesale clients (as defined under the Corporations Act 2001 (Cth)) and is not suitable for distribution to retail clients. This document does not contain and should not be taken as containing any financial product advice or financial product recommendations. This document does not take into consideration any recipient’s objectives, financial situation or needs. Before making any decision relating to a Schroders fund, you should obtain and read a copy of the product disclosure statement available at www.schroders.com.au or other relevant disclosure document for that fund and consider the appropriateness of the fund to your objectives, financial situation and needs. You should also refer to the target market determination for the fund at www.schroders.com.au. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed by Schroders or any company in the Schroders Group. The material contained in this document is not intended to provide, and should not be relied on for accounting, legal or tax advice. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. To the maximum extent permitted by law, Schroders, every company in the Schroders plc group, and their respective directors, officers, employees, consultants and agents exclude all liability (however arising) for any direct or indirect loss or damage that may be suffered by the recipient or any other person in connection with this document. Opinions, estimates and projections contained in this document reflect the opinions of the authors as at the date of this document and are subject to change without notice. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised. Past performance is not a reliable indicator of future performance. All references to securities, sectors, regions and/or countries are made for illustrative purposes only and are not to be construed as recommendations to buy, sell or hold. Telephone calls and other electronic communications with Schroders representatives may be recorded.

Authors

Mihkel Kase
Portfolio Manager, Fixed Income

Topics

Fixed Income
Mihkel Kase
Income
Australia
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