For decades, income investors have relied on government bonds and investment-grade corporate bonds as the mainstay of their income portfolios. These bonds are relatively low risk, which is also appealing to risk-averse income investors.
But during the last few decades, bond yields have declined steadily, as the chart below shows. Before now, this has not been a problem for investors. While the income provided by bonds has declined, this has been handsomely offset by the boost to capital return as yields have fallen (yields and prices move in opposite directions).
Lower interest rates
10 Year nominal yields
Source:Oxford Economics, February 2017. Note: Chart shows yield on 10 year maturity government bond in each country.
Unfortunately, now that yields are close to rock bottom, the income return bonds offer is very low – and with little prospect of capital gains to compensate. We suspect that while yields might rise a little, they are likely to remain unusually low for an extended period. This is because today’s low interest rates are a function of a global “savings glut” caused by slow-moving demographic trends. Eventually, these trends will reverse, but not any time soon, in our view. Accordingly, low government bond yields will probably be with us for some time.
Rather than accept a low income from government bonds, many investors have sought yield from riskier sources of income like high-yield bonds and high-dividend equities. Such assets can offer higher incomes, as the table below shows. It is a strategy that has worked well in recent years, with capital appreciation adding to income to generate good returns. But equities and high-yield bonds are relatively risky assets whose returns are also highly correlated (i.e., they tend to fall in value at the same time). So this approach is not ideal for more risk-averse investors, particularly now that equity and high-yield valuations are looking stretched.
Many investors may be better served by diversifying their portfolios across a much wider range of “alternative” income sources.
This serves three purposes. First, the income available from these alternatives is often higher than that offered from equities and high-yield bonds. Second, investors can rotate away from high yield and equities when they are expensive. Third, the underlying cash flows that drive these alternative sources of income have a low correlation with one another (unlike correlations between equities and high-yield bonds).
If one asset class crashes, the others may not be as badly affected. This means that, by combining several diversified sources of income, one can achieve a lower overall volatility.
What are these alternative sources of income? There is a wide variety, including emerging-market debt, social and environmental infrastructure funds, asset-backed securities (ABS), insurance-linked securities, litigation finance, healthcare royalties and many more.
Historical and forecasted income returns for various assets
Income return: forecasts vs history
3 year forecast
|Global govt bonds||1.5||2.9||-1.4|
|UK Investment grade bonds||3.9||5.9||-2.1|
|Global investment grade bonds||4.1||5.2||-1.1|
|UK cash 3M LIBOR||0.5||3.7||-3.2|
|US High yield bonds||6.5||8.5||-2.0|
|EM Debt (hard currency)||5.9||6.0||-0.1|
|EM Debt (local currency)||6.1||7.1||-1.0|
|Senior secured loans||5.8||5.8||0.0|
|UK infrastructure social||4.6||5.1||-0.5|
|UK infrastructure renewables||5.6||5.4||0.2|
|Asset backed securities (mezzanine)||4.5||5.0||-0.5|
Source: Aberdeen Asset Management, July 2017. Historical averages are based on 20 year histories where available. Income forecasts are based on house long-term expected return models. Total returns are often different from income returns because changes to capital values can add or subtract return. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially. Past performance is not indicative of future results.
- Emerging-market local currency debt. These are bonds issued by emerging-market governments in their local currencies. Yields are much higher than in developed markets, currently averaging 6%. While there have been defaults in the past, lessons have been learned in recent decades and these bonds are now less risky.
- Infrastructure funds. These funds own social infrastructure assets (such as schools and hospitals) with government-backed inflation-linked income, or renewable energy assets (such operational solar or wind farms) that earn a reliable cash-flow stream from a mix of government subsidies and power contracts. These funds have proven to be resilient in volatile equity markets.
- Asset-backed securities. These are pools of securitized mortgages and corporate loans. ABS offers higher yields than corporate bonds of the same credit quality, with a lower volatility and lower risk of default.
By combining a range of these diversified income sources with more conventional income assets, investors can potentially generate an income of around 5%.
By combining a range of these diversified income sources with more conventional income assets, investors can potentially generate an income of around 5%. This is a fair bit higher than the traditional bond-based income portfolio of government bonds and investment-grade credit. But volatility, on the other hand, is only a little higher. In an age of low government bond yields and expensive equities, we think this is an attractive proposition for income investors.
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), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.
Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Among the risks presented by infrastructure investing are substantial commitment requirements, credit risk, lack of liquidity, fees associated with investing, lack of control over investments and or governance, investment risks and tax considerations. Infrastructure funds also include political/governmental, operational, environmental, currency fluctuations, differences in accounting methods and project risks. These risks are generally heightened for emerging market investments. Additionally, development, bidding and ongoing costs in infrastructure projects may be greater than for traditional government procurement processes.