Time to switch gears?


Time to switch gears?

After a decade of easy money meeting the cost of living has become increasingly challenging as yields on traditional income-generating assets have fallen and inflation has picked up. Investors have increasingly had to take on more risk to get less return. However, as the environment begins to shift, bringing with it the prospect of increased volatility and inflation, the role of income-generating assets will become increasingly important.

The good old days are gone

Twenty or 30 years ago, government bond yields sat comfortably above inflation levels. Now they are barely covering the rising cost of living. In fact, in some cases, developed market government bond yields have fallen below the prevailing rate of inflation, leaving investors with negative real yields. See charts 1-5.

Because yield is becoming harder to find, investors have had to look further afield, often increasing risk in their portfolios even though they have been receiving less yield in return. However, while there is no riskless reward, there is certainly an approach that could lead to “rewardless” risk.


Rising volatility

Over the last 10 years, quantitative easing (QE) by global central banks has pushed down bond yields and interest rates to all-time lows. While this has fuelled rallies in both bond and equity markets, it has made it more difficult to generate income. This, in turn, has pushed investors to take on more risk in their hunt for higher-yielding assets.

However, today’s ultra-loose monetary policies are beginning to tighten as global growth appears to take hold and inflation is starting to pick up. The US Federal Reserve has started to raise interest rates and the European Central Bank, the Bank of England and the Bank of Canada have also issued statements indicating similar intentions. As those central banks also begin to slow and even reverse QE, income-hungry investors will be faced with a different set of challenges, including inflation and volatility.

The unprecedented central bank action since the Financial Crisis has pushed bond and equity prices to record highs. As they withdraw this support and allow interest rates to rise in response to inflation, bond prices, for example, are likely to fall. Investors who have taken on more risk will be more exposed to changing prices and their response could be more extreme. At the market level, that could increase volatility as prices change more sharply.

This is unlikely to be limited to the bond markets, as investors’ efforts to reduce their risk exposures are likely to play out in equity markets as well. Consequently, equity prices at all-time highs will also feel less comfortable to investors and these assets may see sharp price changes in conjunction with bonds. As a result, the withdrawal or reversal of QE by central banks could result in an increase in volatility across the board.

In this climate, income-focused strategies can offer investors stability. Bonds, for example, will still pay a fixed coupon (interest payment) even as their price falls. This pushes up the yield an investor generates as bonds lose value. Meanwhile, dividends payments on shares have also historically proven less volatile than share prices. Both can therefore have a volatility-dampening role in a portfolio, which means these income-generating components can play a bigger role in managing the overall downside on equity and bond returns.

We have identified three solutions for income-seeking investors that can help portfolios adapt to these shifting market conditions: flexible fixed income, sustainable dividend growth and inflation protection through listed infrastructure.


Flexible fixed income

Fixed income yields tend to move in the same direction as interest rates. They have fallen over the last decade in line with interest rates, but the opposite is expected to happen when rates rise. This can help offset the volatility of bond prices by helping to absorb capital losses, and may make it possible to generate positive returns. The Bloomberg Barclays Global Aggregate index, for example, has posted positive returns in all but four of the last 20 years.

Simply buying an index may, however, expose investors to unrewarded risk. As the old saying goes, you can’t eat relative returns. Put simply, this means any performance above or below a benchmark won’t necessarily translate into hard cash. It is just a relative measure. With that in mind a flexible approach to global fixed income markets that is not constrained to a particular benchmark can help investors manage downside risk in volatile markets.

Global bond benchmarks are flawed because weightings are based on the amount of debt outstanding – i.e. the biggest borrowers are given the biggest weighting in the index. Instead, managers who deploy a more flexible approach can actively manage duration, country yield curves, sectors, currencies, credit quality or a combination of these factors. This flexible approach enables the manager to dynamically shift the portfolio to better navigate changing market conditions and better manage downside risk.


Sustainable dividend growth

The income generated from sustainable dividends from equities can also help investors adapt to shifting market conditions. The key to this approach is to find companies paying dividends that are likely to grow in a sustainable manner, as volatility undermines the smoothing effect they can have on a portfolio.

Identifying companies that can grow their dividends sustainably means focussing on how those companies are growing. Therefore, investors should seek out companies that generate growth through retained earnings and free cash flows – the key ingredients of sustainable dividends.

Companies that exhibit characteristics of sustainable growth will also show the potential to grow sustainably throughout the investment cycle. One metric for these high-quality companies might be returns on invested capital (RoIC) as companies with a high RoIC typically outperform the wider equity market over 10 years.

A large dividend is not worth much if it is not sustainable. Rather than seeking income by focussing on dividend yields alone, investors should take a disciplined approach to valuations, placing growth metrics above yield to identify ideas with real longevity.


Inflation protection through infrastructure

Lastly, an increasingly popular alternative for income-seeking investors is to invest in a basket of companies whose main service lines are linked to the price of inflation. For example, companies with assets that provide society with the transmission of gas and electricity or the use of toll roads; these have their prices set by government regulators, who allow for a direct pass-through of inflation. As a result, this kind of listed infrastructure company can offer investors dividend growth indexed to inflation, providing a unique opportunity for stable and predictable capital flows with built-in inflation protection.

As the environment changes, bringing with it an increased risk of rising volatility and inflation, income-generating assets can help protect portfolios from downside risks and the rising cost of living by helping to smooth returns. This, in turn, should help investors avoid unrewarded risks in their efforts to generate income.



Charts 1-5: 10 Year Government Bond Yields versus CPI year-on-year change %











        Source: Bloomberg


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

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.

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.