The income challenge
The income challenge
- With interest rates close to zero across the globe investors seeking to generate higher income are not being sufficiently compensated for the risk that they are taking.
- In this environment, it remains more important than ever to diversify an investment portfolio across many different asset types, sectors, regions, rating grades and structures.
- A cost-effective method to achieve risk reduction via diversification is to use an actively managed fund that utilises the broadest investment opportunity set and varies the risk exposures based on valuation (the investor’s compensation for risk).
- Seeking income in investment products that offer the potential of a high coupon or income payment may seem very enticing in the current environment however they often come with hidden risks which will work against the investment when there is some volatility in the market. Sub-investment grade investments, added leverage, and very subordinated securities are just some of the ways in which income can be increased but so too risk within the portfolio.
With the central banks, including the RBA, declaring cash rates will remain close to or below zero for the foreseeable future, income investors have inadvertently been lured by investments promising higher income but coming with a lot of risk. The result is that risk premiums for taking exposure to credit risk (the risk of not being repaid your principal if the issuer defaults) have compressed to very low levels (simply, more people demanding this investment can mean that issuers of the debt offer a lower level of interest income). Whilst the risk of default has generally fallen for debt as a whole, due to government support for economic recovery and the rollout of vaccines, it has not been removed.
Figure 1 below shows the risk premium available on different types of fixed income securities with exposure to credit risk; comparing their current spreads to those at the height of uncertainty in March 2020. The return compensation for taking on credit risk has compressed dramatically, across all ratings grades. For example, the return compensation for investing in US investment grade issuers is now 88 basis points, compared to 292 basis points in March last year. Similarly, Australian high yield is now 266 basis points compared to 784 basis points at the same time last year. This period has been very good for investors that managed to invest in March 2020 but now suggests that for the same investment the compensation for investing has dramatically reduced.
What does history tell us?
The total return on a fixed income security is generated by the yield and the change in the capital value of the investment. The capital value falls as interest rates rise and as expectations of default increases. Changes in capital value is the reason the total returns on different fixed income sectors vary significantly from year-to-year as the income component of the return tends to remain fairly stable.
This is shown in Figure 2 below. Returns from the higher risk sectors, global high yield and Australian hybrids, can be either stellar or very poor. During periods of compressed risk premium, returns tend to be towards the lower end of the range. Being able to assess the relative value between these sectors is key to managing an income portfolio’s risk by avoiding exposure to sectors where compensation for taking additional credit risk is low.
Schroders’ Approach to Income Investing
The key foundations to our approach in income investing are:
- Greater breadth in the investment universe is always preferable to less.
- Implement an investment process conditioned on forward looking valuations to:
a. avoid overpriced sectors and assets
b. vary the total portfolio risk exposure relative to the compensation received.
- We believe that income investing should be focused on generating absolute returns and capital preservation. It is therefore imperative to have an explicit downside risk objective embedded into the process.
- Utilise hedging strategies, such as duration management and foreign currency exposures to manage total portfolio risk through additional diversification.
We believe implementing an investment process with these fundamental building blocks will maximise our ability to generate our return targets, whilst limiting the chance and size of a negative return over rolling 1-year periods. We believe these objectives are fully aligned with the objectives of investors seeking reliable income with capital preservation.
In the current environment of very compressed credit spreads we believe these attributes are even more important. Investors seeking income should avoid higher allocations to funds with limited investment universes, particularly those concentrated in sub-investment grade and subordinated sectors.
Schroders’ Income Funds
We offer investors two income funds.
The Schroder Absolute Return Income Fund (SARI) is a traditional income fund investing predominately in publicly traded, liquid debt securities. To achieve its cash plus 250bp performance objective the fund can invest in a broad array of debt securities, from government to corporate debt, domestic and global issuers, securitised and asset backed and from investment grade to sub-investment grade. Broad diversification and our valuation focus, for varying the asset allocation and risk exposures, is key to achieving our objective of avoiding negative returns over rolling 1-year periods.
The Schroder Multi-Asset Income Fund (SMAIF) (previously Schroder Real Return CPI Plus 3.5% Fund) broadens the investment universe from debt to include limited allocations to equities. In line with our belief that greater breadth is preferable to less, some exposure to equities can provide a more balanced risk and return outcome compared to an approach that extends risk exposures further into subinvestment grade credit or subordinated securities such as hybrids and convertible bonds.
The Schroder Multi-Asset Income Fund is designed for income investors seeking higher returns (the return objective is cash plus 350bp) and who are comfortable with slightly higher risk, but still require a capital preservation focus. The downside risk objective is to limit the size and incidence of a negative return over 1-year rolling periods.
Figure 3 below is a distribution frequency of rolling 1 year returns per return bucket for the Schroder Absolute Return Income Fund and the Schroder Multi-Asset Income Fund (since inception of the Schroder Multi-Asset Income Fund in March 2016). This chart highlights the consistency in delivering on the return objectives and benefits of the downside risk focus with the limited number of occurrences of negative returns (highlighted in the table).
Schroders’ Income Funds may be suitable for the following types of investors:
- Investors seeking regular and predictable income
- Investors seeking a defensive investment that offers protection from rising rates
- Investors seeking a total return solution – with diversification, liquidity and conservative risk profile, the funds provide a whole of portfolio solution for clients seeking income and capital preservation during retirement
For more information about the Schroder Absolute Return Income Fund or Schroder Multi-Asset Income Fund, please speak with your Schroders representative.
This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. It is intended solely for professional investors and financial advisers and is not suitable for distribution to retail clients. The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.