The Power of Income

The Power of Income

A timely reminder about what really drives fixed-income returns and where the opportunities lie. In short: never underestimate the power of income.


With yields currently at historical lows, it’s increasingly common for investors to look for ways to use fixed-income as a reliable source of total return in their broad investment portfolios. In this paper, Product Specialist Robert Abad provides a timely reminder about what really drives fixed-income returns and where the opportunities lie. In short: never underestimate the power of income.

 

Assess the Landscape

Over the past 30 years, yields across global government bond and credit markets have fallen to very low levels. Not surprisingly, coupons across the major fixed-income asset classes have followed suit. The following two charts show how the US Federal Reserve’s (Fed) decision to implement an extended quantitative easing program has served to accelerate the decline in yields across a number of markets (Exhibit 1).
 

Exhibit 1: The Glide Path of Yields and Coupons
 

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

This low-yield, low-coupon environment has presented a global challenge for individual investors, pension funds and institutions who are looking for attractive sources of income or a level of return to meet their investment objectives. The challenge has become more acute due to the myriad investment opportunities now available and the inherent complexities surrounding asset allocation, market timing and risk management. This is not to claim that investors cannot find attractive yield and income opportunities across publicly traded credit markets. Indeed, if investors are willing and able to assume greater risk, higher yields can be found in alternative markets such as private debt, real estate and hedge funds to name a few.

Reaching for yield, however, can be a risky and short-sighted proposition. With each passing year, investors have become increasingly wary about loss of capital (drawdown risk), see-sawing returns (volatility) and the inability to quickly redeem their investments (liquidity risk). These concerns are warranted based on recent market experience. Over the past two years, global financial markets have been roiled by market-moving events such as Brexit, fears of a China slowdown, oil market volatility and the possibility of an aggressive path of Fed rate hikes.

Given the prevailing environment and the likelihood of more market turbulence ahead, what should investors expect regarding fixed-income returns and where can attractive income-generating opportunities be found?
 

Focus on the Math

To gain some perspective on where fixed-income returns may be headed, we examined the drivers of historical returns for various fixed-income sectors over a 30-year period, and the years following the 2008 financial crisis. Based on our analysis, it is clear that coupon income is the most significant contributor to returns over both time periods (Exhibit 2). If these results are surprising, then this analysis should serve as a timely reminder that: (1) coupons are a function of yield upon issue, therefore we can conclude that the yield offered by an investment will have a significant impact on the total return to be generated by the investment over its life, and (2) coupon reinvestment plays a critical role in overall total return performance.

 

Exhibit 2: Drivers of Historical Return

 

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The role of coupon reinvestment should not go underappreciated. Using high-yield as a proxy for all of the higher-yielding fixed-income opportunities, we can see how the decision to reinvest the higher level of income offered by this asset class—despite its price volatility—dramatically impacted cumulative and annualized returns over a specific time horizon (Exhibit 3). The same dynamic can also be observed, albeit to a lesser degree, within US investment-grade credit.


Exhibit 3: The Power of Coupon Reinvestment
 

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Needless to say, this type of analysis is highly dependent on one’s entry point into an asset class. For example, we selected June 2007 (the first month of the ensuing 2008 financial crisis) as the start date of a hypothetical investment into the US high-yield and investment-grade markets. As Exhibit 4 illustrates, income generation in both fixed-income asset classes was more than sufficient to overcome the negative drag from price return over the period and produced (especially in the case of US high-yield) a competitive annualized return versus the S&P 500 (including dividend reinvestment). This showcases the power of compounding interest which should be attractive to any investor seeking steadier, long-term total returns.


Exhibit 4: The Power of Income
 

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Of course, investors would need to embrace the volatility associated with their fixed-income holdings to reap the benefits of reinvestment income. In this regard, investors would have to pursue an investment strategy similar to the concept of dollar-cost averaging. For instance, if bond prices decline (yields rise), the income distributions received will buy more bonds. Alternatively, if bond prices rise (yields fall), the income received will buy fewer bonds. Over time, this approach should tend to reduce the cost basis of the investments held, minimize the impact of timing and enhance total return for the long-term investor.
 

Expand Your Opportunity Set

In recent Western Asset papers, we’ve noted that the global fixed-income market has grown dramatically over the past 20 years due to a number of secular forces and that it now offers investors a much richer universe of investment opportunities across a number of regions, sectors and currencies. In developed markets (DM), the opportunity set has expanded significantly to include corporate debt across the whole credit quality and maturity spectrum, bank loans, mortgage-backed securities (MBS), securitized assets, covered bonds and private debt. In emerging markets (EM), newer asset classes such as “frontier market” debt, corporate credit, local currency-denominated government debt and inflation-linked notes comprise a greater bulk of trading activity. We believe that as time passes, the breadth and depth of the global fixed-income market will continue to attract more interest from retail and institutional investors as they begin to understand the opportunity cost of not diversifying globally.


Exhibit 5: Yield-to Worst vs. Historical Correlation—Last 10 Years

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Yield and volatility statistics reflect U.S. dollar hedged data. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

That stated, investors who have a long-term horizon and are looking to generate high returns should not be seduced by the siren song of esoteric asset classes, highly concentrated sector-specific strategies or any strategy that would only work in a single macro scenario. This, in effect, would expose the investor to more drawdown, volatility and liquidity risk. Rather, we suggest using a multiple diversified strategies approach that should benefit in different environments so that no one strategy dominates performance.

Exhibit 5 highlights the risk, return and correlation profile of select fixed-income asset classes. It exemplifies our view that there is enough variety of appropriate asset classes for investors to build a fully diversified portfolio that incorporates both income- (and return-) generating assets as well as defensive assets.
 

Search for the Right Solution

Looking to the future, we see demand for fixed-income solutions with an income emphasis growing in line with the global demand for income. First, we are in the midst of an unprecedented demographic shift across both the DM and EM worlds due in large part to the aging of populations across North America, Europe and Japan, as well as biomedical advances that continue to extend life expectancy rates globally (Exhibit 6). This


Exhibit 6: A Rapidly Aging Global Population
 

Source: UN Population Division, as of 31 December 2017. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

will likely have profound, long-term implications on how individuals, businesses and governments think about savings and investment.

Second, we believe that other secular forces such as the impact of rising debt levels on global growth and continued advances in technology and innovation will likely have a depressive effect on the long-term trajectory of interest rates. At present, low interest rates have left those on the verge of retirement playing catch-up with their savings, while pensions and insurance companies are challenged with identifying more attractive sources of income-generating assets to meet their future cashflow needs. We believe this challenge will become even more acute in the coming years, leading to continued demand for fixed-income to act as an income/return generator and diversifier against equity risk in a broad investment portfolio.

With this in mind, we believe that investors should look beyond traditional fixed-income strategies, over- come their home biases, and explore another solution that seeks to capture the income and return potential available across the entire global fixed-income spectrum: multi-asset credit. This approach is not generally measured against a benchmark—to offer maximum investment and risk management flexibility—and can be classified into three distinct categories by the level of return and risk it targets (Exhibit 7).


Exhibit 7: Multi Asset Credit Market Segmentation
 

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
 

In Summary

In this low-yield world, it will be difficult for traditional fixed-income strategies to deliver returns in line with historical long-term averages. Global macro and demographic conditions are shifting and different sources of broad market risk are now materializing. With this in mind, we encourage investors to consider actively managed fixed-income solutions that seek to harvest value and income opportunities across the entire global credit spectrum.

 


Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is only for distribution in those countries and to those recipients listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK & Switzerland) this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority.

In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.

Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information Documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.