2017 will mark the 10-year anniversary since the onset of the global financial crisis. Since this time, investors have found it increasingly difficult to find income from traditional sources such as cash or fixed income. This is mostly attributable to authorities worldwide using aggressive monetary policy to try to boost their flagging economies.
At first, central bank base rates were slashed close to zero, followed by the introduction of quantitative easing and in some countries, negative interest rates followed.
This collapse in yields was an acceleration of a trend that began in the 1990s as inflation expectations fell. The causes of which are widely considered to include China’s increased participation in world trade, demographic changes in the developed world and inflation targeting by autonomous monetary authorities.
The collapse in yields has been both a boost and a challenge to investors. Fixed income investors have significantly benefited from this extended bull market, achieving equity like returns from assets traditionally considered to be of lower risk. Gilts, investment grade and high yield debt all produced returns over the last ten years in excess of that achieved by the UK equity market. Ranging between 5.5% and 8.4% a year for 10 years.
Income Investors Forced to Raise Risk
While the benefits from a total return perspective are plain to see, the challenge for income investors is equally clear. As yields have declined significantly, income investors have either had to accept a lower level of income from their portfolios or raise exposure to traditionally riskier assets, or some combination of the two. The challenge in this environment for advisors has therefore been how to achieve acceptable yields for their clients while ensuring that client portfolios remain with an appropriate level of risk. Risk comes in many guises and is not limited to statistical measures of return volatility.
UK commercial property provides a higher yield and the nature of valuing the assets provides a smoothed return profile, however this masks the illiquid nature of the asset which can provide risk to investors. 2016 brought a salutary reminder of this when in July many UK commercial property funds suspended trading in the aftermath of the Brexit referendum.
What Does 2017 Hold?
2017 is likely to bring a further complication for income investors. Not only do they have to consider this balance between income and risk, but the latter aspect is complicated by the question of whether the fixed income bull market is at an end. In an environment where yields rise from such low levels, income generating assets, including so called bond proxy stocks, may not only lag other assets but could more importantly lead to capital loss. Markets issued a stark warning to these dangers in the second half of 2016, as yields rose.
While much of the narrative attributed this rise to the election of victory by Donald Trump, the reality was that yields had started rising in the preceding months. From September to the end of November, broad Gilt indices returned falls of more than 7.5%, with long-dated Gilt indices reporting double digit losses. Sector returns within U.K. equities show a similar story, with bond proxies selling off aggressively. Consumer staples and utilities returned -7.4% and -8.5% respectively against the broad market which produced a modest 0.6% positive return.
While considering the above, it is important to realise that many income investors have mixed motivations. For some, the need for income may well supersede all other concerns. However, for many there is a requirement that their investment portfolio generates income over the long-term and these investors now have some difficult decisions to make. We see valuations stretched in most areas of fixed income, with the same comment applicable to US equities. While emerging market debt and equities provide some attraction, the risk tolerance of many income investors will mean exposure to such assets will be restrained.
Does Cash have a Part to Play?
This brings us to the difficult decision for long-term income portfolios to increase their exposure to cash. While not providing any significant income in the short term, it does provide much needed capital protection. This could be crucial to investors who need to defend their capital in order to protect the ability of their portfolio to generate income over the long-term.
A version of this article appeared in FT Adviser Magazine
