Income investing used to be boring. Portfolios were built from bonds and from the most unexciting and dependable areas of the equity market.
No longer. In recent years, a combination of ultra-low interest rates and quantitative easing has pushed government bond yields close to – or even below – zero. Future returns from sovereign bonds and low-risk investment-grade corporate bonds look set to be low for some time. Meanwhile, equity markets have reached record levels and now look expensive, indicating that their returns will also be muted. And with political volatility in the developed world and geopolitical instability in the Middle and Far East, there is potential for dramatic market reversals. As returns from bonds and equities have been shown to move in the same direction most of the time, they provide little protection from market downturns.
Bonds and equities still have a place in an income portfolio, of course. But income-seeking investors now need to look at asset classes that they would not have considered – or even known about – in the past. Beyond the traditional asset classes of bonds and equities, a broad range of alternatives offer compelling yields and considerable diversification benefits.
Specialist capabilities in several of the more esoteric asset classes may be helpful.
Multi-asset income portfolios invest clients’ money across a diverse range of alternative investments. These include emerging-market bonds, high-yield bonds, absolute return, private equity, corporate loans, insurance-linked securities, infrastructure and peer-to-peer lending.
Some of these alternatives have become increasingly mainstream, with hedge funds and private equity assets now common to many portfolios. These assets tend to be positively correlated with equity markets and therefore unlikely to provide significant protection when markets sell off. Specialist capabilities in several of the more esoteric asset classes may be helpful.
These markets can offer attractive yields. Many have low correlations to bonds and equities. But besides their attractions, they offer specific risks. Some, such as emerging-market bonds, can be highly volatile. Others, such as infrastructure, are highly illiquid. And their relative and absolute benefits can vary over time. A crucial aspect of building an income portfolio is ensuring that there is appropriate diversification among them – thus reducing risk – as well as a focus on the highest-quality opportunities within them.
Many of these opportunities have specific appeal beyond their yields. Corporate loans, for example, offer the opportunity to receive higher returns as interest rates rise. This is because corporate loans aren’t fixed-income instruments but instead have floating-rate coupons – so the holder gets more income as yields rise. With the U.S. Federal Reserve having raised interest rates twice this year already, this is an increasingly important consideration in the construction of an income portfolio.
Insurance-linked securities, sometimes known as catastrophe bonds, also hold considerable attractions. These securities pay investors a regular premium for taking on some of the risk of losses arising from specific events – such as damage caused to property by hurricanes, for example. The bonds fall in value if such events arise, but the declines do not mirror the equity markets. Natural disasters are not correlated to economic recessions.
Cash flows from infrastructure projects do not tend to change significantly with the economic outlook, so their returns are uncorrelated to those from bond and equity markets. Renewable infrastructure is a particular area of interest here, as governments worldwide are seeking to increase investment in sources of renewable energy. As state funding is struggling to provide the required capital, investment funds are stepping in to oversee renewable-energy projects. Although infrastructure investments are highly illiquid, their cash flows do not tend to change significantly according to the economic outlook, so returns from this asset class are uncorrelated to those from mainstream bond and equity markets.
One relatively new asset class is peer-to-peer lending. This allows investors to lend money to individuals or businesses. Peer-to-peer lending companies operate online platforms that match potential lenders with borrowers. Unlike banks, the platform operators don’t make money from the spread between the lending rate and the borrowing rate. Instead, they charge fees for arranging the loans. For lenders, the returns look attractive – especially in an environment of low interest rates. At present, the gross rate of interest (before service fees and losses from defaulting loans) is typically in double figures. That could change if credit conditions were to deteriorate as they did during recent financial crises. Nevertheless, investors could still expect to achieve positive, if modest, returns in such circumstances.
Given the different attractions and risks of these asset classes – and the variety of opportunities within them – achieving and maintaining an appropriate balance of exposures is a key consideration. Genuine diversification could be achieved through a broad range of alternative assets, and this is likely to be vital in the years and decades ahead. It’s certainly never dull.
Diversification does not ensure a profit or protect against a loss in a declining market.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.