The return of yield
The income desert is behind us, but investors need to navigate new income opportunities with care.
Interest rates have risen to levels not seen in the last decade, ending the long drought facing income investors. With quantitative tightening well underway and the peak of interest rates on the radar, is now the time to favour income investing? How do investors navigate this new environment? What are the risks associated with this new opportunity set?
Our analysis suggests:
- Investors no longer need to stretch for income: there are compelling yields on offer across asset classes...
- ...but a reappraisal of risks is appropriate, particularly relating to interest rate sensitivity and inflation.
- A multi-asset approach can take advantage of opportunities across the universe, with the flexibility to respond to changing market conditions.
From an income desert to an income oasis
For much of the past decade the environment for yields was highly challenging. 2022 saw a sharp turnaround, with rising inflation pushing central banks across the world to raise interest rates and bring an end to quantitative easing. With this global interest rate shock in 2022, we’re now seeing an oasis of yields – not just in bonds but across asset classes.
Figure 1 (below) shows the evolution of a blended yield of a multi-asset basket over time. The message is clear: yields across asset classes are back to levels not seen since the advent of quantitative easing.
For US dollar investors, the re-emergence of meaningful interest rate divergence has produced an unexpected benefit. By hedging foreign currency exposure, US dollar investors can benefit from a pick-up in yield on their international investments, while the same time reducing the volatility of these assets by dampening currency volatility.
Including international bonds can also improve the credit quality of income portfolio. For example, European high yield bonds offer both a more attractive yield and better credit quality than their US counterparts (Figure 2).
While opportunities across the fixed income universe now look more enticing from a yield perspective, we believe investors need to pay attention to two key risks: interest rate sensitivity and credit risk.
As was clearly illustrated in 2022, bonds with higher interest rate sensitivity (duration) will fall further in price when interest rates rise.
In Figure 3, below, we show the duration of a range of fixed income instruments against their yields. For example, while EM USD sovereign bonds and European high yield bonds offer a very similar level of yield, the duration of the European high yield universe is less than half that of EM USD sovereign bonds.
Where investors are concerned that inflation pressures remain, the path of interest rates poses a risk for fixed income investments with elevated duration.
Three factors to bear in mind for fixed income in 2023:
- Yields have come a long way. Despite the recent rally, US investment grade credit still yields almost double the levels of a year ago (5.1% on 31 January 2022 vs 2.8% on 31 January 2021).
- Investors should not focus just on headline yields but consider the compensation they receive for key risks. Given current concerns around the stickiness of inflation, and therefore the path of interest rates, and the economy moving into slowdown or recession, interest rate and credit risk warrant particular attention.
- The temporary opportunity available from hedging foreign currency exposure for US dollar-based investors.
With yield aplenty, fixed income seems attractive from an income perspective. However, the additional boost from capital growth could be limited from here. A fall in government bond yields from current levels would likely indicate a recession, in which case credit spreads would be expected to widen, impacting the return potential of corporate bonds.
Alternatively, structurally higher yields would also act as a headwind to total returns. Here, a Multi-Asset approach can be helpful, enabling investors to blend the undeniably attractive income available from the fixed income universe alongside opportunities in other asset classes.
Equities as an inflationary hedge?
On the equity side, dividends have increased over the past year and yield hunters now have myriad options across different markets. Aside from attractive yields relative to bonds (Figure 4), equities have another important benefit: they can help hedge against rising inflation.
Corporate earnings tend to be positively correlated with inflation, as they benefit from rising nominal growth. A number of equity market segments have performed surprisingly well in periods of high inflation.
Banks, for example, have been staple holdings in income portfolios over the years. But looking back at the 1970s we see the economic challenges of the period are not reflected in US banks’ earnings. If anything, banks’ profits increased with the pick-up in nominal growth and interest rates. Today, banks are already reaping the benefits of a similar drivers. Quarterly net interest income of US banks has increased from $137 billion in Q4 2021 to $168 billion in Q3 2022 (Figure 5).
Other sectors that have the potential to shield investors from inflation include materials, energy and potentially REITs. The ability to tilt towards these areas can help investors navigate periods of higher inflation and elevated rates.
As with bonds, where investors might want to avoid the lowest quality credits, within equities, income hunters may benefit from avoiding investing in companies with the highest dividend yield.
Companies in the utilities sector, for example, have historically been paying relatively high dividends. However, rising debt levels in that sector have led to a significant deterioration in corporate fundamentals (Figure 6). This has raised questions over the sustainability of high dividend pay-outs. Intoxicatingly high headline yields might prove to be a mirage.
Indeed, looking back in time, steering away from the highest-yielding stocks would have been a wise choice. We looked at the performance of companies based on their dividend yield and then divided the US equity universe into quartiles, with the first quartile representing companies with the highest dividend yields, and the fourth quartile those with the lowest.
As seen in Figure 7 (below), it was the second quartile of stocks, those with high but not overstretched yields, that have offered the best total returns and risk-adjusted total returns since 2003.
For investors who are concerned about moving into a slowdown or recessionary environment, a company’s financial health, financial flexibility, and its ability to continue to pay its dividend and indeed grow it, are increasingly important.
A multi-asset approach to navigate different market conditions
The income landscape today has changed significantly from the last decade, and options for income seekers have broadened considerably. There are good reasons to believe interest rates will remain elevated for some time, creating opportunities for income investors.
That said, it is always beneficial to consider alternative scenarios. One of the key benefits of a multi-asset approach is that it provides the flexibility to adapt to changing conditions by adjusting a portfolio’s asset allocation. To illustrate this, we have considered two different outcomes and an appropriate income asset allocation in each.
The first “back with a vengeance” scenario assumes that interest rates remain at current levels for the foreseeable future. The second “here we go again” scenario entails a return to the previous decade’s low rates environment, often described as “secular stagnation”.
Scenario 1: Back with a vengeance: interest rate elevation
Focus on high income and inflation protection: lower duration government and corporate bonds; diversification into equity sectors offering inflation protection (financials, REITs, materials).
Asset classes to consider in this environment: US 1-5 year Corporate, US High Yield Index, MSCI World Financials, MSCI World Real Estate.
Scenario 2: Here we go again: the return of secular stagnation
Extend duration to achieve sufficient yield: long duration investment grade and high yield corporate bonds, prefer dividend stocks with stable cash flow
Asset classes to consider in this environment: US 10+ year Corporate, US High Yield Index, MSCI World High Dividend Yield.
In the real world, outcomes are not usually so binary. A multi-asset approach allows investors to respond to the prevailing environment, blending the attractive yields on offer across asset classes, while tilting towards assets which can offer positive returns even in the face of a more challenging outlook.
With special thanks to Caroline Rushmore and Kristjan Mee