The hunt for income based solutions in a land of low yields

The exceptionally loose monetary policies of central banks over the past few years have driven income levels down on many assets, as interest rates have collapsed and government bond yields have reached record lows.

Lower volatility asset classes, such as government or corporate bonds, are no longer able to meet the structural demand for income of an ageing population. In their search for yield, people have had to move up the risk ladder and invest in high yield bonds, emerging market (EM) debt or even high dividend stocks.

But after five years of quantitative easing, the risk premium on high yield or ‘junk’ bonds has decreased so much that in the eurozone they yield just below 5 per cent. With the expected tapering of central bank monetary stimulus now pointing to a protracted period of rising interest rates, there are widespread fears that local currency EM debt in particular, now yielding an attractive 7 per cent, might be subject to further money outflows, hitting the countries with large current account deficits especially hard. And local currency depreciation may offset any coupon offered by this asset class, increasing risk for investors.

Moreover, high quality, high yield dividend stocks, very much on investors’ radar screens in the past couple of years, are now considered overvalued.

So what solutions are available to investors today to meet their need for income? And what are the challenges their advisers are facing?

“Investors who used to rely on lower volatility assets for income have had to reach outside of their traditional risk profile in order to supplement that income they no longer have,” says Gautam Chadda, director of Investment Consulting at RBC Wealth Management. “Our biggest challenge as advisers is making sure that we talk to the clients about the risks they want to be exposed to, in order to achieve their financial goals.”

The trade offs to accept when attempting to attain a higher level of income are a series of risks falling broadly into counterparty or credit risk, transparency of the instrument and liquidity risk. And different clients prefer to take different types of risks.

For example, some may accept counterparty risk, by depositing cash in a lower rated bank offering a higher yield, or they may want to lock up their money for a longer period to achieve higher returns. A stock may offer an attractive dividend yield but it is less transparent than a corporate bond offering a regular coupon, provided it does not default, as the investor has no control of how the company is managed and whether they will honour their dividend policy, explains Mr Chadda.

In a low yield environment, it is important to look at the “total return” for investors, ie investing in assets that are likely to grow in a portfolio of different asset classes, as they might be able to meet their liquidity requirements from capital appreciation too, as well as from income, he adds.

In the equity space, RBC WM favours resilient companies with a high level of free cash flow, offering “attractive and sustainable dividend yields”, mainly in the US, UK and Europe.

With interest rates expected to rise, private banks, including the Canadian institution and JP Morgan, tend to advocate a more defensive and diversified approach to investing in fixed income, generally supporting strategies that have limited interest rate risk exposure (short duration) and employ active credit selection.

 “We miss bonds as the steady income play of the past few decades.” says Cesar Perez, chief investment strategist EMEA at JP Morgan Private Bank. “As global markets transition back to normal growth, inflation and interest rate levels, we believe fixed income is becoming a riskier asset.”

From an allocation perspective, JP Morgan favours “a modest exposure to credit as well as benchmark agnostic total return strategies that can tactically navigate a volatile market.”

Low but steadily rising growth explains the bank’s positive stance on relative plays in European rates over US rates, especially as the ECB will remain supportive of the markets for the foreseeable future. “We rely on absolute return fixed income managers to monetise opportunities in the space,” states Mr Perez.

In equities, JP Morgan favours Europe and the US, forecasting European equities to return low double digits in 2014, around 8 per cent earnings per share (EPS) growth and around 3.4 per cent dividend yield. For US equities, expected low double-digit returns are driven by EPS growth slightly higher than in Europe, with a dividend yield at around 2.2 per cent.

At the sector level, the bank likes cyclicals that are geared toward accelerating global growth and improving capital expenditure. “In particular, we like technology, financials, industrials and pockets within healthcare. Conversely, we expect interest-rate-sensitive sectors and bond-like equities, such as telecoms and utilities, broadly speaking, to underperform,” maintains Mr Perez.

The bank took advantage of the “post tapering calm” in fixed income markets to rotate its core credit exposure into a combination of diversified and relative value hedge funds. And real estate and hard assets are seen as important contributors of inflation protection in portfolios.

But dealing with clients who have got used to the excellent fixed income performance of the past five years is not an easy task, acknowledges Manuela D’Onofrio, head of Global Investment Strategies, Private Banking Division at UniCredit. “Clients believe that asking for a return of 4 to 5 per cent is a modest request,” she states, but in reality, with very low inflation levels in the eurozone or the US, they are effectively asking for a very high real return, of 3 to 4 cent.

“Since we went strongly overweight equities in September 2012, we have been telling our clients that it is no longer possible to extract such high returns without moving up the risk ladder,” says Ms D’Onofrio, recommending clients step out of their “comfort zone” and have an equity exposure of at least 20 per cent, if they want to achieve a return of 4 to 5 per cent.

In the equity space, the Italian bank favours the eurozone and the US, while it has not been invested in emerging markets since March 2013 and has a marginal position in Japan.

UniCredit forecasts the MSCI World to return around 7 to 8 per cent this year, but with increased volatility to 15 and 20 per cent, around 50 per cent higher than last year. Therefore, to those HNW individuals who cannot tolerate volatility, the bank recommends to move into absolute return fixed income funds.

With risk premia so compressed in the fixed income space, it is better to rely on fund managers who can be flexible and exploit both negative and positive movements in markets, by going long and short, states Ms D’Onofrio. What she requires from the selected seven to eight managers in this space is to preserve the capital and generate a minimum annual return, which this year, in a rising rate environment, is expected to be between 2 and 3 per cent gross.

Income generating funds have not traditionally appeared on UniCredit’s preferred fund list. Investors tend to associate the concept of an income fund to a low risk product, mislead by many of these vehicles that declare to aim at generating a steady income over time, she says.

But in reality many of them are balanced funds running an equity risk, as they invest a part of their assets in stocks. Such products have been devised to attract conservative clients to equities, which works well when stock markets are trending upward, but when they start correcting, volatility will take investors by surprise, says Ms D’Onofrio.  Indeed, a 10 per cent correction in the equity market in a portfolio with 30 per cent exposure to equities would wipe out the whole yearly coupon.

Another frequent criticism is that income funds tend to focus on those companies having a track record of paying high dividends, even when, as today, they are fully valued.

Aiming at offering a portfolio that on average generates a higher yield compared to the market is certainly a constraint in stockpicking, agrees Nicolas Simar, head of the Value team at ING Investment Management Advisors. “But when selecting a stock, we combine the dividend yield factor with the dividend sustainability. We want to make sure that those dividends are sustainable and able to grow.”

This leads them to avoid the highest yields on paper, which often means that a “dividend cut is not far away”.

Also, reports Mr Simar, academic research has shown that over the longer term the dividend yield and dividend growth components are the two key drivers of total equity return, generating on average more than 70 per cent of it, with capital gain being responsible for the remaining 30 per cent.

Analysis valuation is a key part of the stock selection. Based on this, ING recently moved away, perhaps “a little bit too early”, from the more stable dividend plays – the high quality growth type of income companies, mostly in the consumer goods or pharmaceuticals which became extremely expensive – towards the more cyclicals, including financials. “But we are still able to generate an attractive yield for the entire portfolio,” states Mr Simar.

In the financial space, insurance companies still offer an attractive yield of 4 to 4.5 per cent, but ING’s strong preference is on banking stocks, mostly in the eurozone.

Banks have now repaired their balance sheets and, as the macro-situation in Europe stabilises, are expected to increase their payout ratio, which is around 30 per cent compared to a European market average of 40/45 per cent.

“I expect this combination of attractive valuations, improved profitability profile and payouts on the rise will make banking stocks in the eurozone one of the biggest dividend growers over the next two to three years,” says Mr Simar.

Continental European banks are preferred to US, UK or emerging market institutions, because they are cheaper and offer an option on the recovery cycle in the continent, which although mild, is from a very low base. High conviction banking stocks in ING portfolios include Intesa Sanpaolo, Société Générale in France and Erste Bank in Austria.

Within cyclicals, Mr Simar likes industrials, including transportation and infrastructure plays, motorway concessions and the steel industry. In the construction sector, for companies such as Saint Gobain, CRH or Lafarge, which have efficiently managed their profit and loss accounts over the past few years, a small pick-up in revenue will have a bigger impact on their earnings side. With a 1 to 1.5 per cent GDP growth in the eurozone over the next couple of years, their dividends have a potential to grow quite substantially, he explains.

Within ING global equity products, the firm has a strong preference for Europe over US, where it is a struggle to find attractive valuations and yields, as cyclicals and financials are trading at much higher multiples. Within its emerging market dividend product, the firm sticks to a more defensive position, although, notes Mr Simar, “value is coming through”.

Most of the dividend products tend to have a value tilt. This means they do well in market corrections, such as 2008, as they are supported by valuations, and are able to participate in the market recovery, as they are able to buy, for example, more cyclicals or financials when they trade at significant valuation discount. “The worst phase for this strategy would be typically when we are getting closer to the peak of the economic cycle, like in 2007, because then markets are not driven by fundamentals anymore but by price momentum,” he says.

The fund selector’s view

Today investors searching for income need to look at the equity market, or at least some parts of it, states Bernard Aybran, CIO multi-management at Invesco.

With many ‘high dividend’ or ‘high income’ funds available on the market which target higher yielding securities, fund selectors have to be very mindful of capital depreciation and dividend sustainability, he states.

 “We are ready to accept lower dividends if we have good reasons to believe they are more sustainable in the near future.”

As the chart above shows, high dividend stocks, represented by dividend Aristocrats –companies in the S&P 500 that have increased dividend payouts to shareholders every year for the last 25 years – started to underperform the S&P 500 last year, as displayed by the falling dark line. This underperformance positively correlates to rising interest rates.

Indeed, high dividend stocks are widely bought for their dividend, pretty much like bonds, and investors tend to buy and sell both in synch, explains Mr Aybran. Besides, many of the high dividend stocks are found in sectors where companies are often highly indebted, like telecom, utilities or Reits. Then, any rise in interest rates, ie falling bond prices, means that the cost of debt will be rising, thus lowering the prospects of future earnings.

“Investing in higher yielding stocks implies you need to have a view on bonds, and I can’t see Western interest rates rising dramatically in the near future,” he says. “However, if investors tend to focus on earnings growth, the higher yielding stocks might not be the best positioned, as they typically operate in low growth sectors.”

Generally the investment focus, which in 2011 and 2012 was on emerging markets oriented companies, since mid last year has shifted to Western-listed domestically-oriented firms, because of investors’ concerns on emerging markets slowing down.

“Emerging markets growth is richly priced in emerging market-oriented companies, so sustainability of earnings has to be found in more domestic oriented companies,” says Mr Aybran.

Also, a traditional sector for income generation is real estate and Reits (Real Estate Investment Trusts). With the exception of the UK and the US, valuations on Reits are quite appealing and generate good yields, he adds.

Dividend sustainability

There are several factors to consider when looking at dividend sustainability, explain fund managers, including quality of the balance sheet, and leverage ratio. “We are very cautions on cyclicals that have a high leverage ratio, for example, because we know that dividends will be the first to be cut in a downturn,” says ING’s Mr Simar.

Schroders’ dividend cutting model calculates the probability of companies cutting dividends based on a series of historical observations. “They tend to differ by sector, but it is important to look for any historical behaviour of the company to increase dividends and have a shareholder friendly policy,” explains Aymeric Forest, fund manager of Schroder ISF Global Multi-Asset Income. Attention to the level of debt means, for example, that his fund does not include many Reits, as they tend to be naturally leveraged.

For the highly intensive capex type sectors, fund managers want to make sure that the free cash flow, ie the cash flow after capex generated by the company, covers the dividend yield. In addition, they say it is important to take into account company specific catalysts, return on equity and quality indicators, to understand whether the firm will be able to grow its cash flow and its earnings. 

Multi-asset approach

Because of low real interest rates, it takes investors three times more capital now than five years ago to achieve the same level of income, notes Aymeric Forest, manager of Schroder ISF Global Multi-Asset Income which gathered $4bn (€2.9bn) since its launch less than two years ago.

Investors have had to start buying riskier asset classes, to reach that five per cent yield, but a fund investing in income opportunities across a broad range of asset classes, regions and sectors, not constrained by any benchmark, would enable them to achieve the same level of yield with lower volatility, of five to seven per cent, claims Mr Forest.

Schroders’ fund draws from an investment universe of 20 asset classes, including “neglected areas” such as equity small caps, municipal bonds, infrastructure or Reits, for which it is really important to be opportunistic, he says.

“Having an unconstrained approach means that we can look across a wide investment universe and avoid chasing income at any price. Currently we are seeing opportunities in developed market equities, which we think should be supported by continued economic recovery.”

However, the biggest allocation tends to be in the fixed income space, in US high yield and investment grade in Europe. In high yield, exposure to triple-C bonds is limited to five per cent and the focus is on companies that tend to be more liquid, in order not to increase liquidity risk in a tapering environment.

Exposure to emerging markets is reduced, and the currency risks are hedged through currency forwards for the totality of the portfolio. If there is a more pronounced loss, there will be interesting opportunity in this field, and then those hedges can be removed and allocation to the asset class increased, he says.

“In terms of sectors, we still have exposure to financials and to some of the banks in the US, but where we start seeing some value is in the energy sector,” says Mr Forest.

Consumer staples are seen as expensive, while dividend growers such as technology stocks are considered interesting, with a preference for more mature IT firms, such as Microsoft, IBM or Cisco, as opposed to Facebook or LinkedIn, which are dear.

The fund invests in around 1200 securities, of which 800 are equities. Schroders manages around $78bn in multi-asset funds, which represent around 23 per cent of its total assets under management.