The past week has been rich in press conferences, speeches and comments from world leaders and entrepreneurs. Despite some inconsistencies, surprises, and doubts, they all seem to agree on an improvement in the underlying economy, be it already in place or about to come.
In the US, better economic conditions, a tighter labour market across all districts and a pick-up in inflation, are fuelling expectations for a gradual increase in interest rates this year, which is being reinforced by recent comments from Janet Yellen’s and other Federal Open Market Committee (FOMC) members.
What would the path to higher US interest rates mean for income strategies? With the US Dollar acting as the global reserve currency, US rates behave as a global “risk free rate,” meaning that an increase could increase discount rates on all other assets. Higher interest rates would of course be beneficial for income seekers over the medium term, but what about the transition from the current extremely low interest rates regime?
Are low yields high risk?
It is well publicised that many parts of the fixed income market that income investors have historically relied upon are now trading at extremely low yields.
The risk of such low yields, unprecedented in modern financial history, is somewhat difficult to discern. A natural human response is to look to the past for guidance and many have done so. A few weeks ago, at the Bank of England blog, Paul Schmelzing looked over 800 years of history and drew relatively bearish conclusions. Others have looked at historic Treasury drawdowns and noted that the worst of these still look muted compared to stocks.
The reality is that the past is unlikely to be a guide to the future, but the issue for investors is more simple than that. It could be that we have reached a “pivotal moment” representing a profound change in environment. However, even if we have not, the starting point of value for many mainstream government bonds means that a not so significant move in yield could deliver a significant loss to investors in terms of total return!
The chart below shows the three largest drawdowns in US Treasuries of the last four years. As you can see, with starting yields so low, these drawdowns can be the equivalent of several years of coupon payments.
Luckily for income investors not all fixed income assets share this characteristic. Many assets offer a margin of safety for US rate increases. There are opportunities out there, and the recent yield increases around the world have only served to create more.
In terms of government bonds, peripheral European bonds have seen sharp sell-offs and offer notably higher yields than they did last year. Portuguese 30 year bonds for example are now yielding over 5%, a pretty decent return for an EU member state where the underlying economic data is improving and where, as Draghi confirmed in his latest press release, interest rates are likely to remain low for some time.
The importance of the margin of safety can be seen in the returns already delivered in other parts of the world. Many emerging market countries had already suffered from the ‘tapering’ phase in 2013, and the collapse in commodity prices. As a result they have been resilient in the recent phase of US rate increases (while some currencies have taken the heat).
In the same way, the corporate bond universe offers a range of regions or sectors which may well be less sensitive to US rate dynamics, either because these increases are already priced in, or because other concerns mean there is already a heightened risk premia.
Of course, these bonds might not have the same volatility dampening effect on a multi asset portfolio that US treasuries, Gilts or Bunds showed in the past. To grasp this opportunity and avoid more significant losses on so perceived “safety assets” investors might have to weather a somewhat higher level of volatility. However, it is often the case that when an asset has displayed idiosyncratic weakness, it can also provide unexpected diversification in the period ahead.
This is where a multi asset approach can be to investors’ advantage. A wider investment universe can help mitigate volatility and find diversification within and across asset classes, and more importantly it can help investors enhance returns and grow the capital over the medium term.
The 3 rules for income sustainability
An income investment strategy can be sustainable and even very attractive in a rising US rates environment, but there are some key rules that we need to follow.
Expand your investment universe: a wider investment universe, with a global reach and different asset classes greatly enhances diversification and opportunities. Moreover, investing in securities that provide natural income can help smooth the journey towards achieving a growing income stream.
Income and capital growth go hand in hand: we cannot achieve attractive income over the medium term if we forget to look after and grow our capital base. A recent blog post has criticised the idea of natural income because it implies that capital management is ignored. However, while this may be true of a single holding, or even a single asset class, the argument ignores the fact that it is possible to construct diversified multi-asset portfolios. Doing so allows for the delivery of a natural income, while mitigating capital volatility. Efficient active asset allocation is key to generating returns and avoiding the risks of investing in assets that, despite providing income, are overvalued and could detract from performance in the medium term.
Give yourself time: income strategies pay you to wait. With short term volatility in the market likely to remain a key feature of 2017, we believe it is important to have a time horizon that allows for transforming those events into investment opportunities. Moreover the real benefits of compounding are to be seen over the medium and long term –patience is a virtue!
Next week, in “The Future of Income, part 2” I will discuss whether it is really the case that income is harder to come by today