The low yields that have frustrated income investors should continue to tick higher in 2018. However, investors will still need to rely on a diverse set of investment opportunities to generate meaningful income in the year ahead.
The changing backdrop: rates and volatility
Income, always a key component of investment returns, is increasingly important, driven by structural demographic shifts. The “baby boomer” generation is entering retirementretirement and needs sufficient income to meet spending needs. But faced with three decades of falling bond yields, Australian investors are now utilising a much wider range of income solutions to meet their goals:
- Rising interest rates: Government bond yields and some corporate bond spreads remain near record lows, despite the better global growth outlook, but the interest rate cycle is definitely turning. As Brandywine Global puts it: “At some point, the catalyst for reversing this anomaly will occur and the forces acting to suppress bond yields will unwind, and could do so rather forcefully. Central bankers in core developed markets will be working overtime to avoid another “taper tantrum,” but it remains to be seen how this feat will be accomplished.” Leading fixed income benchmarks are skewed towards developed-market sovereign issuers with long maturities and high duration risk, making them very exposed to this rising rate cycle. So we are moving into a challenging cyclical environment for traditional fixed income investments.
Yields and dividends of selected asset classes
Source: Bloomberg and Legg Mason, 1/12/17. Australian and US 10 year bonds and ASX 200 dividend yield sourced from the from the Reserve Bank of Australia. US corporate bonds are represented by the Bloomberg Barclays US Corporate Bond Index. Infrastructure is represented by the S&P Global Infrastructure Index (trailing 12-month dividend yield). US High Yield is represented by the Bloomberg Barclays US Corporate High Yield Index (yield to worst). Emerging Market (local currency denominated) is represented by the Bloomberg Barclays Emerging Markets Local Currency Government Index. 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.
- Volatility: Low volatility has been an ongoing investment theme in recent years but as ClearBridge Investments notes: “While quantitative easing acted as a pacifier of volatility, we view quantitative tightening as an accelerant. Firming of inflation, a tighter labour market and stable U.S. growth…should initially cause higher volatility in fixed income markets and eventually cause volatility to rise among equities.” Higher volatility, of course, is not necessarily negative for markets -- but it can unnerve investors.
"Monetary policy accommodation from central bankers around the world is helping underpin low rates, as they continue to take a measured and well-communicated approach to rate normalisation."
– Western Asset
What investors can do
For the most part, Legg Mason’s investment managers believe that the best near-term opportunities for generating income are likely to be in the following sectors:
- Dividends: Australian shares have continued to deliver solid dividends over time, even during periods of rising interest rates. Intuitively this is not surprising as the stronger growth that tends to accompany policy tightening often leads to stronger cash flows that enable higher dividend payments. Indeed, in recent years, the yield on the Australian share market has comfortably exceeded Australian bond yields. Martin Currie Australia remains upbeat about the equity income sector, noting “when compared with near record-low bond yields and term-deposit rates, the dividend income and franking credits from Australian equities look remarkably attractive. Our equity income portfolio remains diversified at a stock and sector level, with a focus on stocks with high return on invested capital (ROIC), modest debt levels, strong market positions and sustainable cash flow.”
Australian yield stocks provide attractive returns
Source: Martin Currie Australia, FactSet, 30/11/17. 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
- Real assets: This sector of the share market includes companies that own ‘hard’ physical assets such as property, utilities and infrastructure. Examples include A-REITs, toll roads, ports, airports, electricity and gas grids. Such companies are strongly associated with dividend income as their revenue streams are relatively reliable. For example, consumers rarely stop heating their homes or driving on roads. Martin Currie Australia manages a fund dedicated to this part of the market and notes that “whilst the potential for bond yields to rise remains a headwind for real assets, the hedging of debt costs will mitigate cash-flow impacts and current yields have already priced in much higher bond yield expectations. This is evidenced by the wide spread of the attractive real asset earnings and dividend yields over relatively low cash rates and long bond yields. High relative yields mean Australian listed real assets are also attractive compared with other global real asset options and this bodes well for this asset class.”
- Emerging market debt: These markets offer coupons and yields that in some cases are twice those available in developed markets. Synchronised global growth, continued low inflation and the relatively slow unwinding of monetary stimulus all suggest ongoing emerging market outperformance. Brandywine Global suggests: “Many emerging markets have made incredible strides in curbing inflation, enacting much-needed economic and political reforms, [and] unlike developed countries, central banks in these emerging economies still have some monetary firepower left, with room to lower rates should the need arise.”
- Global corporate bonds: Very low government yields have made corporate spreads more attractive. The higher coupons available on corporate bonds have often offset price losses, enabling positive returns. Key opportunities according to Western Asset include: “investment-grade, where we are focusing on industries that are deleveraging, and emerging markets, where valuations look attractive both on a historical basis and relative to developed markets”.
- US securitised debt: Securities backed by residential or commercial mortgages, or by auto and credit card loans, could benefit from an improving economy. According to Western Asset: “The fundamentals for real estate and consumers are constructive and we believe these sectors continue to look attractive on a risk-adjusted basis.”·
- US leveraged loans: Leveraged loan investments can potentially benefit from a rising rate environment thanks to floating rates (i.e. adjusted as interest rates go up).
- Real estate: As growth improves, rents tend to rise, enabling property investments to provide higher income returns. In the US, Clarion Partners are positive on the property outlook in 2018, noting: “Our baseline scenario expects demand will strengthen while new supply remains in check, which is expected to result in accelerating net operating income growth and higher property appreciation relative to the last two years. As market occupancy approaches 95%, property owners will be able to raise rents. Because demand is strong in many markets across the country, value-creation opportunities to generate higher total returns in the range of 10-20% may continue to present themselves.”
The road ahead
While the cyclical environment for income investors will be more challenging in 2018 given interest rates on the rise globally, it is the structural themes, particularly the aging population, which will ensure strong demand for income investments longer term. Meeting the requirements of these investors is a project that spans decades and will inevitably require a continued focus on multiple sources of income including sovereign bonds, non-traditional fixed income, equities, infrastructure and property.
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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.
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