Don’t ignore the bigger picture

As interest rates have fallen globally, the search for income has been a prominent narrative driving investment decisions. This has meant income-oriented assets have been “bid up” by the market, compared to other sectors, and are relatively fully priced in Mercer’s view.

In recent years there has been a flurry of “income” type funds enter the market, targeted primarily at the wealth sector or smaller institutional investors.  These can take various forms, but a common theme is an emphasis on yield-rich assets and an almost complete avoidance of lower yielding assets such as sovereign bonds. Such funds come with their own risks – the narrow pursuit of income in today’s low yield environment can offer as much downside to the unwary as the narrow pursuit of capital growth.

Types of income funds

Income products tend to fall into three categories:

Equity-focussed funds which invest primarily in stable dividend-paying companies but may have flexibility to invest a portion in fixed interest securities. Given they are concentrated in equities, for the most part these funds offer limited downside protection, albeit the defensive stock bias provides some insulation

Bond-focussed funds which are fully invested in corporate-issued fixed interest and cash. To bolster income, an allocation may be made to sub-investment grade or unrated securities

Diversified funds which are exposed to sectors as above but add or amplify asset classes with income-producing characteristics, such as listed property or infrastructure.

A dollar is a dollar

When considering such funds, it is useful to have regard to a wider context: A dollar of return is a dollar of return whether it comes from income or capital gain. Indeed, in countries where there is little or no taxation of capital gains, maximising dividends may not be the most tax-effective manner to generate returns

Investment returns are generally enhanced by tilting exposure toward those assets or sectors which offer better value or growth prospects relative to others

(As previously stated as interest rates have fallen globally, the search for income has been a prominent narrative driving investment decisions. This has meant income-oriented assets have been “bid up” by the market, compared to other sectors, and are relatively fully priced in Mercer’s view.)

The income component of an investment should aim to be sustainable but, equally, investors have to be mindful of the capital component of the total return. Valuation is important which entails not paying too much for the assets that are generating income.

‘Benign’ market environment

Income-oriented funds tend to have exposure to assets which have a relatively high correlation to the movement of interest rates, including a tilt to sectors seen as “bond proxies” such as utilities, property and banks. The fairly benign market environment we have been through over the past six years – low interest rates with moderate credit spreads and volatility – has provided a solid tailwind for income-type funds.

A low interest rate environment may well continue into the medium-term; however, that is only one scenario. A concentration on allocations to yield-rich asset classes may prove problematic in certain market conditions, such as a “flight to quality” where credit spreads widen and equity markets fall (to take one example, overseas higher yielding bonds lost around a quarter of their value in the period August-October 2008).

If valuations are stretched and begin to reverse, the prospect of investors incurring capital losses may become a reality. And in an individual sense, those who are near or at retirement are particularly sensitive to a drop in the value of their savings – they may not have the required investing time frame to recoup any losses.

There is also a risk that company dividend streams prove unsustainable, due to either pay-out ratios being too high, or insufficient revenue growth. An active manager can help by taking all the above factors into account and avoiding the riskiest parts of the market, but balanced attention to growth, as well as income, will limit the scale of the challenge.

The above discussion is not to say that an investor allocation to income-generative assets is unjustified. Especially where there is a view that interest rates will be “lower for longer” or for investors that have very clearly defined cash flow requirements – and limited need for significant upside from capital growth.

However, it raises the question as to to what extent investors should make use of income-oriented funds and whether now, in particular, is a good time to do so. A fund with more-diversified factor exposures helps reduce the likelihood of being severely impacted by a correction in any one segment of the market.

Being pragmatic

From a pragmatic perspective, it cannot be denied that a sizeable portion of investors, particularly in the endowment and wealth sectors, have a bias to receiving a steady stream of income arising from their portfolio. Human behaviour is such that regular pay-outs fill a need for “tangible” evidence of a return on investment, and there is a general aversion to drawing down on principal.

It is also true that income-paying assets fulfil a need of providing cash to cover grants, or spending requirements, in a relatively simple manner (even if the selling of units in a product can fulfil a practical need for liquidity with modest cost implications). The challenge for advisers and fiduciaries is to help ensure natural or embedded tendencies do not unduly compromise long-term investment goals.

Given the primary focus of income funds is to provide yield as opposed to an efficient portfolio in total return terms, and given the strong returns of yield-rich asset classes in recent years, caution should be exercised in allowing income-themes to dominate investment allocations.

A focus on yield should not be to the detriment of effective portfolio diversification. Ultimately, a well-constructed suite of different asset exposures should offer superior long-term outcomes to a fund dominated by corporate bonds and high-yielding shares.

David Scobie is a principal at Mercer in New Zealand

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