Investing for income has never been so challenging. Bond yields have been at record low levels for years in the wake of the global financial crisis and quantitative easing programmes. The Covid-19 pandemic saw these central bank policies resume, putting further downward pressure on interest rates.
A 'new normal' for bonds?
On the fixed income side, the role of bonds in portfolios had undoubtedly changed, said Stephen Yeats, global head of fixed income beta solutions and UK head of investments at State Street Global Advisors.
"I think we have to recognise that we are in a hugely compressed yield environment globally," Yeats said. "That creates significant challenges and it does challenge some of the roles that fixed income has traditionally played in portfolios; specifically yield being an obvious one, but also diversification. "This means investors need to be more selective, in terms of which currencies, countries and regions they choose to invest in."
Fidelity Multi-Asset Income portfolio manager George Efstathopoulos supported Yeats' assessment, highlighting the way in which the investment grade and high yield markets have changed in the past decade. "If you look at the composition of investment grade today, it looks significantly worse on a duration basis," he explained. "Durations have been extended at a time when yields are at very low levels...
We have seen a massive ratings downgrade in the investment grade space.
"Ironically, high yield has had a bump up in ratings because of the fallen angels, [while] investment grade has got worse and we have seen more volatility in that space." Remi Olu-Pitan, multi-asset fund manager and co-portfolio manager of the Schroder Life Diversified Growth fund at Schroders, said she and her colleagues had been "trying to find a replacement for bonds" as a defensive asset within a portfolio. She contended that such an asset did not exist in the same way.
She continued: "Rather than having that barbell strategy of risky versus defensive, we think that to avoid that disappointment in terms of your hedges, we are looking more at... a sensible core [of] a wide range of assets that are not necessarily negatively correlated, they have different characteristics." Within this, investors must recognise that the "pursuit of income is becoming slightly more risky", Olu-Pitan said. This means accepting a lower income if investors also want hedging characteristics, or expanding their universe of diversifying assets.
She gave the example of hybrid securities as an asset class that can "help to cushion but not necessarily hedge". The hybrid sector is an example of areas of "niche" fixed income that should be considered by income seekers, according to Duncan Blyth, senior investment manager at Seven Investment Management. "It's less binary now and you have to do a bit more work [to get] exposure to different return drivers, and I think that's where you can still get attractive opportunities with income," he said.
He added: "I think we are in an environment where investment returns are going to be lower and I think we have to just accept lower yields in many cases. "If it is coming from areas like technology, again that is long-term growing dividend streams, then they are also going to be lower. "I think we are so anchored to historically higher yields, we have to be wary of that and an acceptance of lower returns and potentially lower yields is something we just have to accept."
Kleinwort Hambros senior fund analyst Paul Hookway urged investors to "be very pragmatic" and think "outside the box" when allocating to fixed income. Buyers need to "understand which part of the curve you are playing and what the structure is", he added. "So we have invested in Financial Credit, which has done very well for us." Investment grade corporate bonds "play a much smaller role than they have done in the past" in multi-asset portfolios, noted Efstathopoulos.
His team had "turned a bit more constructive on equities" in the wake of the November US election result as well as announcements on Covid-19 vaccines, which Efstathopoulos said allowed investors to "look through some of the more short-term issues and... project with more reliability forward earnings". "A headline would suggest that fixed income is challenged as an asset class, but I would argue that the world is not consistent," said State Street Global Advisors' Yeats. "There are areas where this is more acute, particularly in euros.
But also, I think the yield environment we are in is reflective of the economic environment as well. There has been a huge amount of progress made with the virus but ultimately there are significant risks still out there for investors." For those looking for defensive assets in this new environment, Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management (LGIM), said there was no single answer and he highlighted the changing role of bonds in portfolios.
"Five years ago, people had bonds in their portfolio partly as a recession hedge when equities would tank and bonds would do really well. This has been the benefit of balanced and multi-asset portfolios for a very long time, but this becomes a bit more difficult with yields on the floor. "So in a way, the rise in yields we have seen recently is pretty healthy for the long-term future of multi-asset investors."
There were still bond markets that could offer "steep curves and higher yields", such as Korea, Australia, and New Zealand, he said. However, these markets are not as large as their European or US counterparts so cannot be a solution in isolation. Nevertheless, "they are definitely interesting markets and would provide some downside protection", van den Heiligenberg asserted.
Some currencies can also offer defensive qualities to a portfolio, he added: "There's obviously probably negative carry when the carry trade does really well, but it would provide some defensive characteristics that you normally would expect from bonds."
State Street Global Advisors' Yeats agreed that the US dollar could be a risk hedge "at some level" given the shape of the US treasury bond yield curve, which is starting to look steep by historical standards, while Efstathopoulos suggested the Japanese yen as a cheap defensive option.