Three fund managers discuss the health of the current opportunity set for income investing in their asset class.
A cautious Fed bodes well for higher yielding fixed income
Gary Herbert, Portfolio Manager and Head of Global Credit, Brandywine Global
Since February, we have seen expectations for economic growth moderate; they are still positive and strong, but off their highs. We believe this creates an environment where Central Banks will need to raise rates more judiciously or else derail equity growth and equity multiple expansion.
The Federal Reserve (Fed) is also unlikely to hike overly aggressively if growth has not been inflationary. Since she left her role as chair of the Fed and can talk more openly, Janet Yellen has said that the US is going to see a continued decline in unemployment, but she does not anticipate a big uptick in inflation - we agree.
So, three Fed rate rises seems more realistic than the predicted four this year, while next year two rises is more realistic than three. However, the market is playing on the expectation for the Fed to raise rates more aggressively. So, if that then does not happen, the US dollar will weaken particularly against emerging markets. Also, if the Fed does not need to raise rates too aggressively and you do not introduce the case of a monetary policy error, credit spreads will tighten.
As long we have economic growth without the whiff of inflation that is a really positive outcome. If inflation were to spike that is a risk to our investment themes.
Rising rates will create dividend winners and losers
Mark Whitehead, Head of Income at Martin Currie
As interest rates rise, companies that have become excessively leveraged during an era of cheap borrowing may find the rising costs of that debt punitive. Quite simply, too much financial leverage puts a business model at risk, especially in more difficult operating environments. We have seen this time and again throughout the business cycle, where paying liabilities becomes more difficult as earnings and cash flows fall. This, in turn, could adversely affect growth plans and put pressure on dividends. Credit markets also price-in more risk through higher yields and, as investors fret over a company’s ability to pay its dividend, there’s the knock-on effect of lower equity pricing.
Credit analysis is therefore a fundamental part of our investment process to identify and avoid overly levered companies. Time spent analysing company balance sheets to ensure they are appropriate for the type of business a firm is undertaking is always incredibly valuable. But we believe this kind of work will become even more relevant in the ‘new normal’ of higher rates.
Listed infrastructure - stable cash-flow, stable income?
Richard Elmslie, Co-Chief Investment Officer and Co-Chief Executive of RARE Infrastructure
Publicly traded infrastructure securities such as the shares of electricity, water and airport companies can benefit from the long-term stability of cash flows, lower correlation and beta to other asset classes and the potential for inflation protection.
We believe that the level of income from listed infrastructure is likely to rise where it contains direct or indirect links to inflation. For instance, regulated utilities in the UK, Australia and South America have their prices adjusted by inflation at regular intervals. North American utilities, on the other hand, have an indirect link to inflation through a target nominal return on equity which they earn on their asset bases. Therefore, as inflation increases so do their return on equity targets. Given this inbuilt inflation pass-through mechanism and the ability to invest in their asset base, we see the income delivered to investors increasing.
Investing in essential services that continue to invest in their asset base and pass through inflation brings limited risk and the potential to grow income.