Holding on to income in a world of low yields

In the ultimate sign of how hard the hunt for yield has become for private investors, Citi Private Bank calculates nominal returns on a broad-based portfolio of global bonds will reach only 1.5 per cent in 2015, after allowing for costs of hedging back into a major currency such as the US dollar. 

“Yields are so low that investors won’t easily be able to hit their income targets,” says Steven Wieting, global chief investment strategist at Citi Private Bank in London. “Trying to be a conventional bond investor in a world of low yields is tough.”

In common with many other wealth managers, Citi favours a solution based on a combination of alternative, illiquid fixed income investments and equity dividends. Others eschew the dry land of illiquid assets in favour of more liquid material. The liquid/illiquid issue is perhaps the area where wealth managers show greatest divergence in the hue and cry for yield. 

All parties realise, however, that we have come to a key juncture in wealth management. The time has come for advisers to persuade clients that the days of relying on high-grade sovereign bonds for their income are over. 

A two-pronged solution to the search for yield, based on an adventurous approach to fixed income and an enthusiastic embrace of equities, is on the table at BNY Mellon Wealth Management.

The group believes clients should say yes to “YES”. This is the acronym for the firm’s Yield Enhancement Strategy, a US mutual fund investing in fixed income instruments which offer more than sovereign bonds, but with wide diversification to reduce overall risk (see chart below). 

In late 2014, the highest allocations were 29 per cent apiece for corporate bonds and municipal debt, with substantial allocations of 19 per cent for floating rate loans and 15 per cent for high-yield bonds. This allocation to high-yield reflects, says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management in New York, a benign view of this sector, based partly on a view of strong future global and US economic growth in 2015. Investors targeting income should put close to 15 per cent of their portfolio in a YES-type strategy, he suggests.

For clients with higher risk appetite, BNY Mellon WM recommends a holding in the Global Credit Alternatives Strategy managed by London-based affiliate Alcentra, a European direct lending boutique owned by BNY Mellon. Investors in Alcentra can aim for yields of 8 to 12 percentage points above Bunds, says Mr Grohowski. The sub-investment grade loan market which Alcentra inhabits is, he believes, “one of the few areas which I think have the potential to see double-digit income returns”. 

The banks’ withdrawal from lending in Europe has created opportunities for investors to make money in both primary and secondary loans. Opportunities in the primary market have arisen because many mid-sized companies have been abandoned by their banks even though they retain sound business prospects. The secondary market has grown because banks are anxious to improve balance sheets by reducing their loan books. 

But BNY Mellon WM also sees a need to go outside the bond universe in search of satisfactory income levels. Its Balanced Income Portfolio contains an allocation to fixed income of only 62 per cent – 3 per centage points less than normal. 

The equities allocation emphasises stocks likely to pay handsome dividends. “I think we’re set for a multi-year period of very good dividend growth,” says Mr Grohowski, who thinks that in the coming years, US dividend yields above typical current levels of 2 to 4 per cent are achievable. His reasoning: “Dividend payout rates are at record lows, and companies have strong balance sheets.”

On the downside, income investments that, according to Mr Grohowski, “look a little bit overvalued” include preferred stocks, real estate investment trusts in both the US and Europe and “in particular” utility stocks. 

Although BNY Mellon WM is enthusiastic about the loans market, many clients are put off by illiquidity. 

“You have to be really sure that you don’t need the money for a period of time,” says Christian Nolting, global head of discretionary portfolio management at Deutsche Asset & Wealth Management. 

“So for mandates which are trading on a daily basis we clearly cannot have a majority in illiquid assets, even though it’s a good way for clients to reap the illiquidity premium.” 

Having said that, he emphasises that clients will have to wade into deeper waters than previously. “Clients are on the hunt for yield,” notes Mr Nolting. “Although there is not much yield, there are some areas where you can get it, but these are areas such as high yield which come with risk.”

Other wealth managers regard the search for liquidity as a problem in itself. “Liquidity is over-priced,” says Citi’s Mr Wieting. “We think investors should be careful not to overpay for it.” To put it another way, investors enjoy a premium for putting money into investments that are relatively illiquid – with a converse cost for liquid assets. 

Citi likes European high-yield bonds, which are quite illiquid, and bank loans, which are more so. “Stepping into the void left by the banks provides very attractive returns to investors,” says Mr Wieting. “It allows long-term investors to capture illiquidity premia, which is something I think they should do.” 

Returns in the low double digits are achievable, he says, on the non-performing loans of fairly sound companies which have good prospects of eventually paying them off, with lower but still attractive returns for less risky loans. Some analysts put this illiquidity premium at about 3 per cent.

Citi Private Bank also sees strong value in parts of the high-yield market. The late 2014 collapse in oil prices abruptly pushed up the yield on the paper of many US high-yield oil producers, with yields as high as 9.5 per cent for some “undistressed” companies, notes Mr Wieting. 

In common with BNY Mellon WM, Citi Private Bank also sees the appeal of investing for equity dividends as an income solution. “We like equities because of equity income,” says Mr Wieting. For mid-risk portfolios, its global equity weighting is 6 percentage points overweight at 57 per cent. Mr Wieting describes equity dividends as “number one” in Citi’s search for income solutions through public markets, with “credit risk”, including high-yield and loans, as “number two”. 

For some private bankers equity income has one distinct advantage over huge swaths of the fixed-income market: liquidity. “A lot of the fixed income market lacks liquidity,” says Christian Gattiker, chief strategist and head of research at Bank Julius Baer in Zurich. He cites a structural reason: reforms to the banking system, in the wake of the 2008 financial crisis, that are designed to increase stability. Banks are required to hold more capital as collateral for their bond trading positions. By increasing the cost of trading, this has reduced liquidity. 

Fixed-income illiquidity is a problem for Julius Baer because it makes it harder for clients to exit positions in response to signs that interest rates are rising. Many wealth managers expect rate rises in the US and UK, and, in the longer term, in the eurozone. 

But Mr Gattiker is not dissatisfied merely with the illiquidity of bonds. He is also lukewarm about the yields offered by high-yield – their core attraction. “High-yield was the buy of a generation in 2009, when we saw spreads for high-yield bonds of 20 percentage points above US Treasuries,” he says. “But today this buying opportunity has gone.” 

Julius Baer’s novel solution is to recreate the characteristics of high-yield and standard corporate bonds, through buying other instruments. It purchases high-quality government and corporate bonds for the duration risk – the risk that the price of the bond goes up or down in response to changing rate expectations – and equities for the credit risk. This is, says Mr Gattiker, a more liquid alternative to buying high-risk corporate bonds at comparable yields. 

Possible equity plays mentioned by Mr Gattiker for 2015 include buying the 10 laggard stocks in the Dow Jones Industrial Average Index with the highest dividend yields. This group includes the information and communications technology company AT&T and the fast-food chain McDonald’s. 

In contrast to BNY Mellon WM, Julius Baer also likes European Reits as an income play, with yields of 3.5 per cent achievable in this sector. 

This wariness about illiquidity is echoed by ABN Amro Private Bank – for the majority of its clients. Its ultra high net worth clients – those with €25m and above – are often happy to go into illiquid investments. However, those with less money than this are reluctant to do so. 

As a result, “we don’t have loans, which are not very liquid”, says Didier Duret, chief investment officer at ABN Amro Private Bank in Amsterdam. Instead, the Dutch bank is even more aggressive than most other wealth managers in seeking
a solution to low income by going into equities.  

“Wealth managers used to run money with a big chunk in bonds and a small portion in equities,” says Mr Duret. “Equities were the risk engine of the portfolio, and bonds the income part. But this is upside down now.” 

His explanation: “Because yields are low in fixed income, unless you take big risks you will have a very low yield.” As a result, “with the equity part you have to capture the dividend yield, so it has become the income-generating part of the portfolio.”

Responding to this, ABN Amro Private Bank is heavily underweight in bonds and heavily overweight in equities. For a mid-risk profile, it has a tactical allocation to bonds of only 37 per cent, far under its neutral weighting of 55 per cent, with an allocation to equities of 40 per cent, 10 percentage points above its neutral allocation. 

The good news is that Mr Duret thinks income yields on equities can be very attractive. The Euro Stoxx 50 offers an average dividend yield of around 3 per cent, he notes, “but you can have a yield of 3.5 to 4 per cent if you go into the consumer sector, including companies like Unilever.” 

Compared with what you get for bonds, it is very reasonable, he says, particularly given the low rate of eurozone inflation. 

At 0.3 per cent, this leaves real-term income returns of 3 per cent plus for some stocks, notes Mr Duret – above the historical average. These good dividend yields exist because of analysts’ low expectations for European economic growth and corporate earnings – what he describes as “a kind of permafrost of pessimism about Europe”. If the permafrost can provide a firm base for dividend yields, it will be highly useful for income-hungry private investors.

Given all these opportunities – and their potential flaws – what kind of income returns can investors hope for, in the coming years? They should not set their hopes too low, says Mads Pedersen, co-head of asset allocation at UBS Wealth Management in Zurich. He thinks nominal income returns of 4.5 to 5 per cent are “realistic” for the coming five years, from multi-asset dollar-based portfolios that try to achieve both income and capital gains. Investors should still aim for positive real returns, he notes. 

The difference between the low-yield era of now and earlier eras, he says, is that in the old days they could achieve a positive real return by putting 50 per cent of the money in cash and the rest in government bonds. These days, however investors will have to take more risk to get the same result.