GSAM’s Phillips: Balancing sustainable income and long term growth
Nick Phillips, head of third-party distribution for EMEA and Asia ex Japan at Goldman Sachs Asset Managmeent (GSAM), comments on the current crossroads of income and growth.
In our view, investors seeking a mix of income and capital growth from their investments face two key challenges today.
First, as interest rates rise, the income generated from traditional bonds may not offset price depreciation, thus resulting in negative total returns. Essentially, investors who have looked to traditional fixed income assets for income generation – for example, US treasuries, UK Gilts, German Bunds and investment grade corporate debt – have significant duration risk embedded into their portfolio and this creates concerns over capital preservation.
Second, we believe equity markets in many places are no longer cheap and valuations in the higher yielding segment are arguably stretched. As such, balancing the need for sustainable income and long term capital growth is a major challenge.
The most important message for investors is not to stretch for yield in the current environment. We feel fairly comfortable saying we have the capability to deliver about 5% income, but would be extremely hesitant stretching significantly above that level.
Simplistically, we do not believe the additional income – be it from buying longer dated or lower quality bonds, or high yielding equities – is sufficient compensation for the additional risk investors take on.
In bond markets, longer-dated bonds offer higher yields, but also carry far more interest rate risk than shorter-dated bonds. This is a major concern in an environment where rates are likely to rise. In credit markets, risk premiums have declined and we believe valuations are not as attractive as they have been in the recent past.
For example, in the lowest-quality segment of the high yield market, compensation for credit risk appears relatively low to us. However, this rating category includes a very wide range of issuers with varying credit quality. By investing in securities with attractive fundamentals at the higher end of the rating category, rather than simply reaching for the highest-yielding bonds, investors could earn an attractive yield with less credit risk.
In equity markets, similar caution must be taken. While income-oriented investors are understandably attracted to stocks with the highest yields, these tend to have the least amount of growth potential, most levered balance sheets, highest payout ratios and most stretched valuations.
As such, not only is the entry point less supportive of long term capital appreciation, but any deterioration in earnings quality could immediately impact companies’ ability to maintain dividend payments.
By sacrificing a small amount of current yield, we believe investors can buy companies with more robust fundamentals and ultimately more sustainable growth. Not only is this likely to be positive from a total return perspective, it can also result in rising dividends.
Given the risks that exist in some of the more traditional income generating asset classes – for example, investment grade sovereign and corporate bonds and high yielding equities – what other opportunities do investors need to consider?
As we’ve suggested, we think one of the biggest mistakes many income-seeking investors make is limiting themselves to just those traditional sectors.
Firstly, there can be a meaningful yield pickup by incorporating some of the non-traditional asset classes. Asset classes like energy infrastructure, in particular related to the North American shale oil and gas revolution, real estate investment trusts (REITs), business development companies (BDCs), high yield and subordinated bank debt can offer yields of between five and eight per cent, considerably higher than traditional investment grade bonds and stocks.
Secondly, these asset classes are typically less sensitive to rising interest rates and can perform well during the growth phase of the cycle. In the current environment, we would therefore have greater belief in their ability to provide a positive total return, as well as a decent level of income .
When building a multi-asset income and growth portfolio, we think it is important not to stretch for yield, but to balance this with the need to provide capital growth over time. We also think investors must look across the widest opportunity set possible.
If investors limit themselves to just traditional income generating asset classes, they potentially miss out on many opportunities that could enhance their ability to generate income, as well as growth.
We would also argue that investors need to adapt to changing conditions over time and be dynamic in how they approach allocating across asset classes. For example, in times of greater stress investors need to have the flexibility to adjust overall asset allocation to a more conservative stance by tilting their portfolio toward fixed income, which can be less risky than equities.
Furthermore, understanding the interest rate environment and actively managing the portfolio’s overall interest rate sensitivity – duration risk, essentially – is a critical tool in the current environment. By tactically adjusting a portfolio’s interest rate risk, investors can increase their ability to generate income and enhance potential total return.
Finally, when it comes to income generation we believe the most important lever for success is understanding the companies you are invested in. This means having a fully integrated view of the business that encompasses both the debt and equity opportunity, rather than looking at these in isolation. By building a portfolio from the bottom-up and discriminating at the security level both within and across asset classes, we believe investors can find companies that offer a better combination of strong fundamentals and attractive valuations. In doing so, they can improve the income stability and sustainability of their portfolio.