How can European investors generate income in a low interest rate, high volatility environment?

While the European Central Bank (ECB) may not have fired a ‘bazooka’ on December 3 as some had predicted, the additional measures that were announced in support of its quantitative easing programme included another reduction of the deposit rate, taking it further into negative territory.

One of the ECB’s key targets in promoting a solid recovery in the eurozone is to improve credit conditions – partly by making it unattractive for European lenders to hoard cash through parking it with the central bank – and in doing so, help companies and households to reduce their debts. Negative interest rates on short-term government bonds are now the norm across the eurozone, creating a difficult backdrop for European fixed income investors that could continue for some time.

European investors have also been challenged by market volatility, with the region’s bonds and equities both seeing spikes during 2015. By the relatively subdued standards of bond markets, volatility in the eurozone was particularly high in the second quarter. For example, in the German Bund market, 10-year yields moved from close to zero in April to nearly 1 per cent by early June as sentiment about the region’s inflation and economic growth improved. European equity markets had their own surge in volatility in August, driven by concerns that a slowdown in the Chinese economy might signal a wider global downturn, and the European version of the Vix (the so-called ‘fear’ index) topped 40, its highest level since 2011.

So how should European investors respond to this changed investment landscape? With European investors becoming a little less conservative in recent years and starting to shift some of their assets into equities, a greater flexibility in asset allocation, looking across the whole spectrum of equities and fixed income, is something they might consider.

For bonds, when searching for the most attractive income-generating opportunities, it makes sense to consider not just government bonds, but other areas of fixed income such as corporate credit. Spreads on corporate paper have widened considerably since the volatility seen in global markets during the summer, amid much talk of a tightening of the credit cycle for companies. Such speculation seems overdone to us, and we believe it has provided an opportunity to pick up debt issued by high-quality European companies that carefully manage their leverage, debt maturities and balance sheet liquidity.

Given the ongoing low interest rate environment fostered by the ECB’s quantitative easing programme and our positive outlook for European equities in general, simply reaching for the highest-yielding stocks in Europe may not be the best approach when seeking income. In the Franklin European Income Fund we look for companies with sustainable competitive advantages such as a resilient business model that ensures dividend security and growth even in more challenging economic circumstances. Sound financials and attractive end markets are other considerations. These factors, we believe, help to ensure that a company’s dividend is sustainable and likely to continue to grow over time.

Of course, market environments can quickly change, and an end to the era of low interest rates has been predicted by some analysts for many years now, only for the “lower for longer” scenario to prove remarkably enduring. When the US Federal Reserve finally raises US rates, predictions of an inflexion point for interest rates globally will probably grow louder.

However, the eurozone’s economic recovery is a pale shadow of its US equivalent and has been brought about to a large extent by a weaker euro and lower oil prices. While countries such as Spain and Ireland have made progress on reforms, the continuing absence of meaningful structural improvements in other member countries means the eurozone will remain a low-growth environment for some time to come, in our view. It is hard to see the ECB shifting from its current highly accommodative stance in the near term, and policymakers are likely instead to keep interest rates close to historic lows until they can be more confident that the region’s recovery is self-sustaining. 

Against that backdrop, we think European investors would do well to ignore the background noise and instead focus on the opportunities for long-term income generation across a wide-ranging investment universe of equities and fixed income. In this respect, mixed-asset or balanced funds – investing in both bonds and equities – can offer an attractive solution.

David Zahn is head of European Fixed Income at Franklin Templeton Investments