Outlook 2018: Generating Income
Generate Income in 2018
Investing for Income

 

The low yields that have frustrated income investors should continue to tick higher in 2018. However, investors should expect to rely on a diverse set of sources beyond Treasuries and investment-grade bonds 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, thanks to structural demographic shifts. The U.S. “Baby Boomer” generation is entering retirement, along with aging populations around the developed world, and needs sufficient income to meet spending needs. Legg Mason’s investment managers envision two major influences on income investments in 2018:

  • Rising interest rates
    Government bond yields and some corporate bond spreads remain near record lows, despite the improved global growth outlook. However, as Brandywine Global believes: “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.” Leading fixed income benchmarks are skewed towards developed-market sovereign issuers with long maturities and high duration risk, leaving investors in traditional strategies very exposed to this rising rate cycle.
     

Yields and dividends of selected asset classes

Yields and Dividends



Source: Bloomberg and Legg Mason, December 1, 2017. US bonds are represented by the Bloomberg Barclays U.S. Aggregate Index. 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). Emerging markets (US$ denominated) are represented by the Bloomberg Barclays Emerging Market USD Aggregate Index (yield to worst). US High Yield is represented by the Bloomberg Barclays US Corporate High Yield Index (yield to worst). 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 labor 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.

Interest Rates 2018

"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 normalization."


– Western Asset        

Our investment managers believe that near-term opportunities for income investors will continue to lie outside traditional fixed income: 

  • Infrastructure:  Infrastructure companies are strongly associated with dividend income, with the potential for relatively high yields compared to other asset classes. Infrastructure revenue streams are also relatively steady, as consumers rarely stop heating their homes or driving on roads. According to RARE Infrastructure, rate-based growth continues to drive earnings growth and dividend growth for utility companies or toll-road operators.
  • Emerging market debt:  These markets offer coupons and yields that in some cases are twice those available in developed markets. Synchronized global growth, continued low inflation and the relatively slow unwinding of monetary stimulus are together supportive of ongoing emerging market outperformance. Brandywine Global believes: “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.
  • Dividend stocks: Large-cap U.S. yield stocks have continued to deliver dividends over time, even during periods of rising interest rates. As the chart below shows, U.S. dividend yields rival bond yields, so income is not just the domain of bonds. 

Rising Interest Rates


  Outlook 2018:
  New Year's reSolutions


    •  Harnessing Growth

    •  Generating Income

    •  Managing Risk


 

Income – it’s not just bonds 

Government Yields


Source: Bloomberg, December 1, 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

 

  • Corporate bonds: Very low government yields have led many investors to the higher coupons of corporate debt. According to Western Asset: “Key opportunities 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.”
  • Securitized 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.”
  • Real estate: As growth improves, rents tend to rise, enabling property investments to provide higher income returns. 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%, U.S. commercial 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% 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 income requirements of these investors is a project that spans decades and will inevitably require continued diversification of yield portfolios into non-traditional fixed income, equities, infrastructure and property.

 

 

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

 

2018 Interest Rates

After solid gains this year in most asset classes, investors are asking how long the momentum can continue.
 

Read More  ➜

Equity and Bond Valuations

Forecasts for growth in 2018 are positive, but our managers believe a selective approach will be needed to capture value. 
 

Read More  ➜

Active Strategies

As inflation continues to take root, can active strategies help investors protect their portfolios from downside risk?
 

Read More  ➜

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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.

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Unmanaged index returns do not reflect any fees, expenses or sales charges.

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