How can investors find sustainable income?
A decade on from the start of the global financial crisis, the search for yield continues unabated. Our 2016 Global Investor Survey found that 41% of respondents were seeking an income yield of at least 8% and over half were seeking at least 6%.
Yet such demands look increasingly hard to meet. One particular problem is that an increasing proportion of income yield is being generated by a shrinking pool of both shares and bonds.
Fixed income: yields are not always what they seem
Take bonds. Many offer “running” yields of more than 4%, on the assumption that the investor will receive back at least what they paid for the bond. Yet many – if not most – are trading above their repayment value, which means any investor who holds the bond to redemption will be guaranteed a capital loss.
For example, anyone buying a bond for $105 will receive coupon payments which may equate to a 4% yield on that value, but then get back only $100 when the bond matures. So, although headline income levels (or running yield) may seem attractive, it is probably more important to focus on the “yield to redemption” that takes into account this $5 loss and is almost certain to be a lot lower.
It may be possible to trade out at a better price but, even so, avoiding such losses is now much more dependent on market timing and security selection than in the past.
A changing universe
As well as a change in price, there has also been a change in the quality of the bonds available. A historical comparison of the US dollar investment grade1 bond market makes this clear. Almost half of the universe rated by credit rating agencies (which help determine the creditworthiness of borrowers) is now rated at the lower end of the spectrum (BBB), up sharply from less than 30% in the late 1990s.
These changing dynamics have pushed investors towards higher yielding securities. While these are likely to be less sensitive to rising interest rates, they may be more sensitive to anticipated default rates and financing conditions as they offer less protection in the form of the lender’s financial strength.
The reach for yield also leads to sector concentration. Amongst US investment grade bonds, for instance, investors who want a yield of 3.5% or higher are forced into buying commodities and subordinated financial debt2. Similar patterns can be seen in other global markets.
Fundamentals are deteriorating
The dependence of investors on an ever-decreasing pool of higher-yielding securities comes at a time when corporate fundamentals are beginning to look vulnerable. While most corporate borrowers can cover their interest payments relatively comfortably, the total stock of debt outstanding has been growing for a number of years. This means that the market may be vulnerable to even small moves in either global interest rates or central bank liquidity.
Equities: concentration risk
Over the long term, dividends have provided more than two-thirds of real (i.e. inflation-adjusted) returns for US equities, and nearly 90% for UK equities. Up to now, dividend yields have held up well in most regions. With similar yields hard to find elsewhere, investors have sought out high dividend equities. Developed market companies have responded by generally maintaining their support for dividends.
However, the degree of concentration in high dividend benchmarks is striking. For example, 50% of the market value of the MSCI Europe High Dividend Yield Index is accounted for by its top ten constituents.
This degree of concentration is also apparent from a sector perspective, with a fifth of the yield of the global MSCI High Dividend Yield Index coming from financials alone. Worryingly, as we saw with credit, the key contributors are again financials and commodity-related. This means that investors may be unwittingly concentrating their exposures in the same areas on both the equity and the credit side.
There are ways to generate a high income, but they come at a cost:
- a likely trade-off in fixed income markets between higher income today and a guarantee of less capital tomorrow (if a bond is held until it matures);
- an increase in credit risk in corporate bond markets, exposing investors to additional risk of loss;
- over-exposure to certain potentially vulnerable sectors and companies in both fixed income and equity markets.
Our belief is that, rather than focusing on the alluring mirage of a high headline income yield, investors would be better served focusing on a more sustainable level of income. The more diversified these sources of income, the more resilient the portfolio will be to shocks.
While such a focus may well result in a lower level of immediate income than is available elsewhere, the long-term prospects for both income and total returns are likely to be greater.
1. Investment grade bonds are the highest quality bonds as assessed by a credit ratings agency. High yield bonds are more speculative, with a credit rating below investment grade. Generally, the higher the risk of default by the bond issuer, the greater the interest or coupon.↩
2. In the event of borrower default, owners of subordinated debt will not be paid out until owners of higher-ranking debt are paid in full.↩
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