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Seeking sustainable income in a low rate environment

 

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 09 October 2017

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09 Octobre 2017

 

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Income generation will likely continue to be at the forefront of investor needs.

The income dilemma

The great income shortage

Income shortage is set to be one of the biggest challenges for investors in the future. An aging population and the need to reduce the high levels of debt in developed markets could result in potential cuts to public welfare and, consequently, increase the need for income in retirement. Demand for income is also highly relevant in the institutional space for investors, such as pension funds, that require predictable cash flows. We believe that income generation will continue to be at the forefront of investor needs, as four major secular trends shape the outlook and behaviour of investors.

Fig 1

 

 

 

 

 

Supply of “safe” sources of income (AAA sovereign bonds) has shrunk by 67% over the last 10 years.

The search for income comes at a time of financial repression, with many developed market government bonds trading at zero, or very low yields, that in most cases are below inflation. In fact, we estimate that around 70% of developed market government bonds currently trade at negative real yields, exacerbating the income shortfall. In addition, the income from “safe” government bonds, the traditional source of income for investors, could come under further pressure from a lack of supply, as the amount of AAA rated sovereign bonds has shrunk by 67% over the last 10 years, despite an 82% increase in overall government bond supply.

Fig 2
 The 2017 General Government Gross Nominal Debt (Billions USD) by S&P’s Rating is calculates using the Nominal GDP and Gross Debt in % of GDP from the IMF WorldEconomic Outlook, April 2017. Standard & Poor’s Ratings as of May 10, 2017 compared to December 31, 2007 available on Bloomberg. AAA (highest possible rating)through BBB are considered investment grade; BB or lower ratings are considered non-investment grade. Standard and Poor’s Copyright © The McGraw Hill Companies (2017). Copyright © 2013 by McGraw-Hill international (UK) Limited (S&P), a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.  

 

The great income shortage comes at a time when we are approaching a major paradigm shift from monetary to fiscal
policy.

 

 

 

 

 

 

Financial repression is set to continue despite a gradual increase in interest rates.

This shortage of income is happening while we approach a major paradigm shift driven by a less dominant role for Central Banks in favour of an expected loosening of fiscal policy. In the U.S., the handover from monetary to fiscal stimulus has already started, with the Federal Reserve on a path of rising rates alongside expectations of a progrowth fiscal stance from the Trump administration. Europe and Japan are a different story. Here, ultra-loose monetary policy remains in place, but the fiscal agenda is also taking centre stage amid looser fiscal conditions. Major developed economies are also escaping the deflationary trap supported by stronger economic conditions, although we do not forecast a new period of structurally high global inflation. In our view, the income reality is that the way out from accommodative monetary policy by major Central Banks is expected to be slow, despite the improving cyclical economic and inflation outlook, and the imbalance between income demand and supply will persist. Consequently, real yields could remain very low or in negative territory as infl ation could rise faster than yields, as has happened in recent months.

Fig 3
 Real 10 Years Government Bonds Yields calculated with di  erence between the yields on the generic 10 year government bonds and the headline infl ation on the country of reference.

 

 

Regardless of the zero interest rate environment, many investors continue to hold a signifi cant allocation to currency and deposits.

Are investors’ portfolios positioned to face future income challenges?

Despite the ongoing zero interest rate environment, investor allocations remain very conservative and in a period of financial repression such an allocation could risk eroding households’ wealth in real terms.

Fig 4

 

The hunt for yield has led to significant spread tightening over the last 18 months.

In addition, investors have continued to pile into bond portfolios, with €467bln net flows globally in 2016 (73% of the total global net fl ows1). Indeed, in their hunt for yield many investors have moved higher in the risk spectrum towards lower graded bonds. This trend, combined with the current accommodative monetary policy has resulted in further spread tightening in credit markets.

Fig 5
Merrill Lynch indexes. Euro IG = ML Euro Corporate Index, Euro HY = ML Euro High Yield Index, US IG = ML US Corp Master, US HY = ML US HY Master II Index, EM Corp = ML Global EM Corp Index.

 

 

For investors, the dilemma is how to seek income in a world of low yields, tighter credit spreads and potentially higher risk in bonds.

In our view, this increased focus on fixed income, which has been a traditional source of income, could pose a significant challenge for investors if interest rates start to rise more broadly.

In fact, a 0.5% rise in yields on 10 year bonds over the next 6 months could result in significant drawdowns on a mark-to-market basis, and credit markets could also be exposed to higher volatility when the still accommodative monetary policy in Europe starts tightening.

Fig 6

 

The calculation shows the total returns pre-tax based on an interest shock analysis, on generic 10-year government bonds, supposing a shock of 50 basis points with a horizon from August 31, 2017 to February 28, 2018. This example represents a hypothetical illustration of what potentially happens to Government bond prices when yields rise. It does not represent a specifi c investment. This graph represents the e  ect a rise in interest rates has on the price of the 10-year government bonds being shown. This hypothetical example is for illustrative purposes only and does not represent any particular Amundi product or strategy. This e  ect only applies if the bonds are sold prior to maturity. Changes in interest rates may have a different effect on other types of fixed income investments based on various factors including duration and credit rating.

 

In the future, we believe investors will need to rethink their traditional asset allocation and focus on new ways to seek sustainable income in an environment of low and slowly rising yields, but better economic conditions.

 

It's not just about income. Downside risk management and capital appreciation are also important factors to consider when designing income solutions around investors' needs.

Things to watch when investing for income

In the search for income, the starting point is to understand investors’ priorities. In fact, each investor may have a dierent set of income goals (primary and secondary) which may also be linked to the role that income investment plays in their overall portfolio (for instance, investors may be searching for diversified sources of income, whereas other investors may be searching for a more holistic approach to managing their income sources, especially if they are already retired). Different risk profiles and capital preservation requirements should also be considered, as well as an investor’s appetite for long-term capital appreciation.
Accordingly, we have identified three major income objectives in what we call the Triangle of Income Investor Goals (see Fig.7.). These three objectives are Income Enhancement, Downside Risk Mitigation (in terms of capital preservation and volatility) and Capital Appreciation Potential (the potential for long-term growth above inflation).

Fig 7

These three goals are very interconnected. In fact, while the major goal of an income investor is to gain a predefined, annual level of real income, this amount depends on both the income yield of the underlying investments and also their capital appreciation. Therefore, if we consider an investment with a constant target income yield, any drawdown (or capital appreciation below inflation) on this investment would not only imply a potential wealth reduction for the future, but also a lower level of real income delivered to the investor in the short-term.
Consequently, in their search for income investors should carefully assess yield and the risk/return profile of each investment.
With this in mind, we assess the challenges involved in targeting each one of our three Income Goals in the current environment and the approach investors should consider when seeking sustainable sources of income.

Income: harder to find after the crisis

Most income investors (retail and also institutional, such as pension funds) usually target a defined and stable level of income/yields in their portfolios. How challenging is it to achieve an income goal in the current environment? For example, 3.8%, which is the average yield for US treasuries over the last 20 years (Fig.6.). 

 

 

After the Great Financial Crisis, the income available in the market has shrunk and also the role of different asset classes as income producers has changed over time.

When looking at historical data on the evolution of yields across different asset classes (Fig 8), we see that the yields available have generally dropped since the Great Financial Crisis (2008) compared to pre-crisis levels and the sources of income have also changed over time. In fact, an investor that was targeting a hypothetical yield of 3.8% in the years before the Crisis could have achieved this level by investing in the “safest” segments of the fi xed income space (government bonds and credit investment grade). After the Crisis, there has been a signifi cant change in the sources of income available. With yields in core bonds so much lower, the only asset classes with yields persistently above our 3.8% target have been global high yield bonds, Emerging Markets bonds, US energy MLPs (Master Limited Partnership) and global high dividend stocks. These asset classes have traditionally been more volatile than government bonds and credit investment grade debt.

 

 

 

 

Today income investors should explore opportunities across a broader range of asset classes in an effort to avoid the low yield trap.

Fig 8
US Govies= JPMorgan GBI US, EMU Govies = JPMorgan GBI EMU , Global IG Credit = Bloomberg Barclays Global Aggregate Corporate Bond, Global HY Credit =Bloomberg Barclays Global High Yield Bond, EMBI = JPMorgan EMBI Global Diversifi ed Blended, CEMBI = JPMorgan CEMBI Diversifi ed Broad Composite Blended, Global Equities = MSCI World, Global Equities HD = MSCI World High Dividend Yield, US MLP = Alerian MLP, Target = 3.8% that is the 20 years average yield on the US Treasuries as in Figure 6. Yields are: Yield to Maturity for JPMorgan Indexes, Yield to Worst for Bloomberg Barclays Indexes and 12 months Dividend Yields for MSCI Indexes.

In our view, seeking a stable source of income has become more challenging since the crisis. The above analysis suggests that nowadays income investors should rethink their approach to income investing that has traditionally focused on “safe” bonds and consider how they can access a wider array of income sources.
In conclusion, we believe that for income investors, it’s time to consider broadening their perspective, taking a more active approach and exploring a wider range of potentially higher-yielding investment opportunities across different asset classes with varying levels of risk. 

When exploring a wider range of income opportunities, investors should be aware of the downside risk associated
with each investment.

Downside risk: how to manage it

As with all investments, an investor’s tolerance for risk is a relevant factor to consider in the design of income investment solutions. Risk should be measured not simply in relation to volatility, but also in terms of potential drawdowns. Investors should be aware of the downside risks associated with each asset class, which may be exposed to different types of risk: credit, market or liquidity risk.

 

 

Investing for income requires a constant assessment of the
changes to the underlying risk environment in order
to identify how the risk profile of each asset class changes over time.

Fig 9
EMU Govies = JPMorgan GBI EMU, US Govies = JPMorgan GBI US, EUR IG Credit = Bloomberg Barclays Pan European Aggregate Corporate Bond, US IG Credit = Bloomberg Barclays US Aggregate Credit, EUR HY Credit = Bloomberg Barclays PanEuropean High Yield Bond, US HY Credit = Bloomberg Barclays US Corporate High Yield, EMBI = JPMorgan EMBI Global Diversifi ed Blended, US Equities = S&P 500, Global Equities HD = MSCI World High Dividend Yield, European Equities = MSCI Europe, European Equities HD = MSCI Europe High Dividend Yield, Global REITs = FTSE EPRA/NAREIT Global, Global Infrastructure = Dow Jones Brookfi eld Global Infrastructure Index, US MLP = Alerian MLP Index. All indexes are total return in local currency. Yields are: Yield to Maturity for JPMorgan Indexes, Yield to Worst for Bloomberg Barclays Indexes and 12 months Dividend Yields for MSCI Indexes. Max Drawdown is the largest 1 year decline in value registered since December 2010 based on an analysis on monthly data. Drawdown – The peak-to-trough decline during a specific record period of an investment, fund or commodity, usually quoted as the percentage between the peak and the trough. Yield is the Yield to maturity for bonds and the dividend yield for equities.

 

In fact, for income investors, drawdowns could have a signifi cant impact on the potential to generate income in the future. Therefore, investing for income requires a constant assessment of the changes in the risk environment in order to identify how the risk profile of each asset might change over time.

When assessing current risk conditions, we see that higher yielding opportunities are available in the US HY market, where liquidity risk (which we analyse in terms of liquidity in both the primary and secondary markets and on the basis of fl ow dynamics) and credit risk (which is based on our assessment of whether the credit spread compensates for default rates) are at their highest, and EM Bonds, where there is also some liquidity and credit risk, but at a much lower extent (see Fig.10.).
Equity markets, and in particular the European Equity High Dividend segments, could also be a source of higher potential yield that is not exposed to liquidity and credit risk, but is exposed to market risk (volatility).

 

 

Low volatility could persist amid improving economic prospects and current accommodative Central Bank policy,
but volatility spikes may occur on the back of geopolitical risks.

In our view, a multi-asset approach based on the combination of different sources of income, with different types of risk exposure may allow an investor to build a target income/risk profi le that is not otherwise available in the market. However, this type of approach requires ongoing active management, in response to the constantly evolving risk/return and income landscape.

Fig 10
EMU Govies = JPMorgan GBI EMU, US Govies = JPMorgan GBI US, EUR IG Credit = Bloomberg Barclays Pan European Aggregate Corporate Bond, US IG Credit = Bloomberg Barclays US Aggregate Credit, EUR HY Credit = Bloomberg Barclays PanEuropean High Yield Bond, US HY Credit = Bloomberg Barclays US Corporate High Yield, EMBI = JPMorgan EMBI Global Diversifi ed Blended, US Equities = S&P 500, Global Equities HD = MSCI World High Dividend Yield, European Equities = MSCI Europe, European Equities HD = MSCI Europe High Dividend Yield, Global REITs = FTSE EPRA/NAREIT Global, Global Infrastructure = Dow Jones Brookfi eld Global Infrastructure Index, US MLP = Alerian MLP Index. All indexes are total return in local currency. Yields are: Yield to Maturity for JPMorgan Indexes, Yield to Worst for Bloomberg Barclays Indexes and 12 months Dividend Yields for MSCI Indexes. Max Drawdown is the largest 1 year decline in value registered since December 2010 based on an analysis on monthly data. Drawdown – The peak-to-trough decline during a specific record period of an investment, fund or commodity, usually quoted as the percentage between the peak and the trough. Yield is the Yield to maturity for bonds and the dividend yield for equities.

 

For example in recent months, financial markets have been highly complacent and volatility has been quite low compared to historical levels across almost all asset classes. In a period of improving economic prospects and current accommodative monetary policy from Central Banks, volatility on risk assets could remain low but subject to likely volatility spikes on the back of geopolitical risks as recent tension in North Korea testify.

Over the medium-term, we believe that this trend should revert as a consequence of the paradigm shift and we, therefore, take this into account when assessing the market risk of each asset class.

 

 

 

 

 

 

 

We believe that an active multi-asset approach can potentially benefit investors by providing a holistically managed solution across all asset classes, with a strong focus on managing downside risk.

Fig 11

 

EMU Govies = JPMorgan GBI EMU, US Govies = JPMorgan GBI US, EUR IG Credit = Bloomberg Barclays Pan European Aggregate Corporate Bond, US IG Credit = Bloomberg Barclays US Aggregate Credit, EUR HY Credit = Bloomberg Barclays PanEuropean High Yield Bond, US HY Credit = Bloomberg Barclays US Corporate High Yield, EMBI = JPMorgan EMBI Global Diversifi ed Blended, US Equities = S&P 500, Global Equities HD = MSCI World High Dividend Yield, European Equities = MSCI Europe, European Equities HD = MSCI Europe High Dividend Yield, Global REITs = FTSE EPRA/NAREIT Global, Global Infrastructure = Dow Jones Brookfi eld Global Infrastructure Index, US MLP = Alerian MLP Index. All indexes are total return in local currency. Yields are: Yield to Maturity for JPMorgan Indexes, Yield to Worst for Bloomberg Barclays Indexes and 12 months Dividend Yields for MSCI Indexes. Max Drawdown is the largest 1 year decline in value registered since December 2010 based on an analysis on monthly data. Drawdown – The peak-to-trough decline during a specific record period of an investment, fund or commodity, usually quoted as the percentage between the peak and the trough. Yield is the Yield to maturity for bonds and the dividend yield for equities.

 

When investing for income, volatility is just one of the many risk measures to watch. Liquidity and Credit risk are also important factors to consider when building an income portfolio.
The high yield market is an example of an asset class that is typically exposed to these risks. Despite the higher income potential available in this segment, the liquidity risk premium may not always be enough to compensate for these risks and during these times investors should consider sourcing income from different asset classes / strategies (including, for example, carry from EM currencies) or focus on a disciplined selection of single securities to help ensure that the risk taken is properly remunerated.

 

 

 

 

Income investors interested in capital appreciation should consider equity income, an asset that could also benefit during a period of paradigm shifts.

 

Focus on Income and Capital Appreciation

 

The third goal we are considering is capital appreciation. This is the objective that many income investors target, especially when investing with a long-term horizon.
For investors who are less sensitive to short-term downturn, we believe that sourcing income from equities can offer the best capital appreciation potential over the long-term.

 

Fig 12

In addition to higher capital appreciation, at a global level stocks are currently delivering income well above the 10-year government bond yields and we believe that this trend is set to continue as we see more and more focus on dividend growth and dividend sustainability from corporations.

 

Fig 13
Dividend Yields are the 12 months dividend yields for the local MSCI indexes, High Dividend Yields are the 12 months dividend yields for the local MSCI High Divides indexes, Govt Bond Yields are the Yields of the local Generic 10 Year Government Bond.

 

This means that for income investors wishing to diversify their income allocation, equities can provide interesting yields, while at the same time not exposing investors to duration and credit risks. It also offers some protection against infl ation, as historically dividends tended to increase in line with inflation.
Moreover, in a period of expected higher growth and infl ation, equity markets could also benefit from supportive market sentiment.

Fig 14

In our view, income from equities can benefit investors who place higher priority in income generation (with managed duration, credit and liquidity risk) and capital appreciation (both cyclical and structural).

 

 

It is now paramount to carefully select each income opportunity and be ready to reallocate portfolios as the paradigm shift phase we have in front of us could reshuffle the risk and income cards once again.

Conclusion

We believe that income investing is set to remain at the forefront of investor needs. For investors, the income dilemma relates to how they can seek a sustainable income in a world of low yields on so-called safe assets, tighter credit spreads, rising infl ation and potentially higher volatility on fixed income driven by the gradual normalisation of monetary policies. 

Against this backdrop, we believe investors need to rethink their asset allocation and focus on new ways to seek sustainable income aligned with their investment goals. In doing this, investors should focus on three major income objectives: income enhancement, downside risk mitigation and capital appreciation potential, as different approaches are required to pursue these different goals.

Investors targeting income from bonds could embrace a flexible, multi-sector approach which seeks to exploit selective opportunities across the fixed income spectrum including Emerging Markets bonds and currencies, while helping to manage duration and credit risk.

Investors who want to target a higher level of income, compared to what is currently available in the fixed income space, but with a strong focus on downside risk management could consider a Multi-Asset approach. This selects income opportunities across a wide range of asset classes and calibrates the different sources of risk (market, credit and liquidity) with the aim to build portfolios that are resilient to different market scenarios and seek to deliver a sustainable income stream over time. This approach can also benefit from the potential to generate capital appreciation and also mitigate possible inflation surprises through an active allocation to real assets.

Finally, investors targeting income and growth or wanting to diversify their income portfolio out of the traditional fixed income space, could consider investing in Equity through the selection of stocks targeting high dividends. Despite higher volatility levels, equity income investing can also help diversify risk as it is not exposed to credit and liquidity risk.

 

BERTINO Claudia , Head of Amundi Investment Insights Unit
FIOROT Laura , Deputy Head of Amundi Investment Insights Unit
IACCARINO, CFA Piergaetano , Head of Equity Target Income
SANDRINI Francesco , Head of Multi-Asset Balanced, Income & Real Return
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