Interest rates are still scraping their record lows, forcing investors to remain creative when it comes to generating steady income. But with central bank policies changing and market dynamics shifting in the year ahead, what about managing risks?
For the last eight years, central bankers have cut interest rates, engaged in quantitative easing and in some cases taken rates negative as they have sought to squeeze inflation into the global economy. Because central bankers have used government bonds as a policy tool for reflation, this has challenged a major source of traditional income, as these bonds yield virtually nothing and yet have grown increasingly expensive. It is no surprise that valuations today are looking stretched in some parts of the market. In order to continue to find income, investors will need a greater emphasis on diversification with more attention to risk management.
We do see some dangers in over-reaching for yield, particularly at this point in the market and economic cycle. Investors whose primary goal is to achieve income need to still consider the risk they are taking to get that yield as well as the capital return they’re generating. Now is not the time to be maximizing risk in the hopes the bull market continues. Instead, the focus should be on producing regular income with a flexible, globally diversified approach and on maintaining the potential to deliver total return.
As investors, we are favouring equities with the ability to grow their income stream. Dividend yielding equities with the potential to provide capital appreciation as well as grow their dividend stream through time look attractive.
European equities offer a diversified stock selection opportunity and are generating on average 4% dividend yields. We’re trimming our exposure to global equities slightly where more capital is being returns via buybacks rather than dividends. We are gradually beginning to increase our allocation to emerging market equities, where we have a constructive view. Importantly globally across equities we’re seeking out investments that offer value and the potential for compelling income.
The ability to be flexible, tactical and nimble in finding income has been very important in the low yield environment. An interesting example of a non-core source of income, as part of a broadly diversified portfolio, has been US non-agency mortgages. This allocation provides a compelling and less correlated income stream to the broader portfolio.
Another asset class that we favour is preferred equities, which sit in the middle of the capital structure between equities and bonds. They pay a dividend and are typically issued by US banking institutions. We’re able to use extensive security selection analysis to find attractively high yields and to manage duration exposure in this allocation.
We’ve been trimming our allocation to high yield as we think value in the asset class has been somewhat eroded, but we continue to see it as a relatively attractive source of income. At these valuations, investors are likely to get their coupons but not much in terms of capital gains.
How multi-asset income investors manage interest rate risk in the year ahead will be pivotal, considering the pivotal central bank transition underway from easing to tightening.
If interest rates gradually start to move up because the market is becoming comfortable with improving global growth and the dissipation of deflation scares we’ve had in the last few years, that’s a positive for risk assets and portfolios such as ours that incorporate some cyclicality should be well positioned.
We are also managing our interest rate risk through hedging. We have been focused on the duration—or interest rate sensitivity—of the fixed income portion of our portfolio. Anticipating gradual upward pressure on interest rates, we remain short five-year Treasury futures in order to reduce portfolio duration.
With interest rates on a gradual but inevitably rising path, having the flexibility to scour the world for yield across different income sources is more crucial than ever.
Michael Schoenhaut is a portfolio manager on the JPMorgan Global Income Fund