Investors have been rapacious in their hunt for income and, in many cases, have killed the golden geese on their quest. Yields on government bonds slumped, then yields on investment grade corporate bonds, now even high yield and emerging market government bonds appear to have little upside. It can occasionally appear that investors have little choice but to turn to equity markets. But this creates its own problems – most notably that of diversification. So where are the other, over-looked, sources of income for investors in the current climate?
In most cases, investors have given up expecting to be saved by a rise in interest rates. The UK yield curve suggests that rates will not start rising for at least another two years. The UK Government has consistently pushed out its austerity plans and now predicts they will continue until at least 2017, with David Cameron last year suggesting that they might continue to 2020 and beyond. In this climate, any rise in interest rates could kill off a nascent recovery and so seems unlikely.
A similar picture is seen across almost all developed markets. Although the Federal Reserve may call a halt to quantitative easing in 2013, chairman Ben Bernanke has said any normalisation of interest rates is unlikely until 2015. Europe is still debating whether it should have QE, and a hike in interest rates is not on the cards.
This climate has long been reflected in global government bond markets, but in 2012 it had a profound effect on corporate bond markets too. High yield had an exceptionally strong year, with the average fund up 19.3 per cent. Even the investment grade sector saw equity-like returns with the average fund in the IMA £ Corporate Bond sector rising 13 per cent during the year.
The top global grade companies are now able to issue corporate debt at record low levels. In October 2012, Nestle issued €500m worth of four-year debt at a coupon of 0.75 per cent. The average coupon on three-to-five year corporate debt hit as low as 2.4 per cent, according to the Barclays benchmark index.
As a result few investors now see any real value in government or corporate bond markets. John Chatfeild-Roberts, head of Jupiter’s Merlin Multi-manager team, says that corporate bonds look better than government bonds, but offer relatively little value and are likely to deliver the coupon at best in 2013.
Andrew Wilson, head of investment at Towry, has lower fixed interest exposure across his portfolios than he would ‘ever have thought possible’. He began reducing fixed income and duration when gilt yields were at 3.9 per cent. “We were a bit ahead of the curve, but who could know that investors would carry on buying bonds with negative real yields?”
David Hambidge, head of multi-asset investment at Premier Asset Management, says: “The ‘less risky’ asset is no longer ‘less risky’. Selling equities and buying high rated corporate bonds at the moment is a bit like telling your boss you want a pay cut and then fixing it for 10 years.”
So investors face a dilemma: A 2-3 per cent yield is simply not enough for many retirees. The yield on equities is still relatively strong, but is eroding with every leap up in the stockmarket. Investors need alternative sources of income from a risk management perspective and to boost the overall yield on their portfolios.
“The top global grade companies can issue corporate debt at record lows”
This has prompted a variety of different approaches. For example, Wilson says that all income-generative assets now look expensive and therefore, for Towry Law clients, takes all income from capital. This can also be more tax efficient:
He says: “Taking our income from capital means we do not have to restrict ourselves to higher yielding asset classes, limiting our investment remit. Yielding assets have often become expensive in recent years. Before 2008 a lot of people would say ‘all you need is an equity income fund’, but then in 2008 the average UK equity fund was down 28 per cent. Higher yield funds were stuffed full of banking stocks. I would argue that in many cases yield has underperformed. Dividend yield is just one measure of value – ‘value’ has performed better than yield. From time to time it does very well, but it is not consistent.”
A number of investors have gone hunting in other parts of the bond market. Peter Doherty, manager of the Tideway Global Navigator fund, says there is still value in those parts of the bond market with an uncomfortable history.
He says: “We have invested in financials and subordinated financials. We want the riskiest bonds in the safest companies – Barclays, Standard Life, Legal & General, and Bank of America. They have a high profile, so we buy the mezzanine or subordinated debt. You can still find 5-12 per cent in that space, but they have some volatility and risk.”
Infrastructure has been another popular choice. The listed infrastructure funds have performed well and paid an inflation-adjusted income stream. However, infrastructure as a theme is now very much ‘discovered’. Yields are still relatively attractive – 5 to 6 per cent in most of the infrastructure investment trusts – but they have come down.
Hambidge says: “We still like listed infrastructure, though it has become a much more popular and crowded trade. There is some cause for concern that a number of these trusts are trading at a premium to NAV. This should set some alarm bells ringing.”
Others have been focused on equities, but ensuring that they diversify globally. Chatfeild-Roberts says that his main source of income across his portfolio remains equities, having looked at areas such as floating rate notes, but not yet invested. Robert Burdett, joint head of multi-manager at Thames River Capital, says that he is diversifying his UK equity income exposure through groups such as small cap specialist Chelverton and his global equity income exposure through funds such as Veritas, Lazard and Somerset Emerging Markets.
But each of these investors is also looking in unconventional areas for income generation. They have all recognised that conventional bond and equities are not enough to cope with the current interest rate environment. With that in mind, these are some of the credible alternative income strategies that multi-managers and other investors are considering.
Hambidge still maintains that income, as an overall investment strategy, is sound. He says: “The beauty of income money is that you are paid to wait. If the asset is cheap, the price will look after itself.”
Floating rate notes
The biggest problem for most investors with bond markets is not their low yields, or the risk of default, it is the potential for a rise in interest rates or – perhaps more crucially – the expectation of a rise in interest rates. The UK 10-year Gilt has already started to price in the end to the QE programme, rising from 1.84 per cent at the start of the year to its current level of 2.12 per cent. With yields so low, any rise in interest rate expectations could dent capital returns significantly.
Enter floating rate notes. As the name suggests, FRNs pay a floating rather than a fixed rate of interest and are therefore not vulnerable to interest rate rises. The interest payment is usually linked to quarterly changes in inter-bank lending rates, which will rise with base rates. As interest rates rise, the interest payments on an FRN will rise and investors should start to seek them out, meaning that their price will rise.
Two main players have attracted interest in this area: TwentyFour Asset Management and Neuberger Berman. The TwentyFour Income fund is a London-listed closed-ended fund targeting less liquid, higher yielding asset backed securities, usually with a floating rate. These securities do not offer sufficient liquidity for a daily-dealing open-ended fund, and the group says this part of the fixed income market has been largely overlooked as a result.
Hambidge has been a supporter of the TwentyFour fund. He says: “The key is that returns are floating and therefore not linked to Libor. It is about identifying income that is also good value. This means that when interest rates do rise, we won’t be hurt by rising yields.”
The Neuberger Berman Global Floating Rate Income fund is similarly structured and has been backed by the Thames River multi-manager team. Burdett says: “We fear duration risk – a rise in interest rates. This means we have nothing in government bonds, but it also means that we are trying to find niche areas for sources of income. The Neuberger Berman Floating Rate Note fund is currently yielding a little over 6 per cent. This is the same as a high yield bond fund at the moment.”
Burdett says there remains plenty of stock specific risk in this part of the market and it is less liquid than high yield. It is therefore important to pick a skilled manager with a credible track record of selecting the right securities. The Neuberger Berman fund also has redemption triggers in place. If it trades at a discount to NAV consistently, investors can redeem 50 per cent of their holding. This has kept the fund trading at near-par in its two year history.
A number of the more conventional strategic bond funds have also been taking exposure to FRNs. For example, Jon Mawby and Steve Roth, co-managers of the GLG Strategic Bond fund, have significantly increased the portfolio’s exposure to FRNs and credit default swaps to reduce the portfolio’s sensitivity to rising interest rates.
The CG Portfolio – Dollar
This index-linked government bond fund has been supported by Chatfeild-Roberts. He has looked to marry yield generation and inflation protection and this fund does both. He says: “This invests in US Tips – inflation-linked treasuries. It also invests in corporate index-linked bonds, but we are not as keen on that area. We cannot see why, if inflation took off, a corporate would issue an inflation-linked bond, but the Tips management is strong.”
The fund launched in May 2009 and is up 46.19 per cent from launch. The bulk of its assets are currently in 5-10 per Tips. It is part of the CG Asset Management stable, which includes Peter Spiller’s long-running and top performing Capital Assets trust. It is now £351m in size.
Real estate lending funds
Banks used to provide the lion’s share of funding for European commercial real estate. As banks have sought to exit property lending under pressure from regulators to improve their capital adequacy, they have been offloading their portfolios at lower valuations. It has left a vacuum in the market for funding. Some of the larger commercial property groups have been able to turn to insurance companies and bond markets, but smaller companies with higher risk assets have been left high and dry.
A number of groups have sought to take advantage of this gap in the market. Several groups tried to drum up support for investment trusts of this type last year, but the notable winner was the Starwood European Real Estate fund. Starwood lend to the ‘higher yield’ end of the property market at higher loan-to-value ratios. This allows them to charge higher interest rates and pay a higher income to investors.
Hambidge says that property debt is a theme that will grow and grow over the next few years: “The Starwood European Real Estate fund came to the market at the end of last year. Traditional lenders are busy deleveraging and this fund is building up a quality book of property. We will see a number come to the market over the next few months and it may become fairly mainstream.”
Burdett is also a supporter: “This is a well-established property business. It is a specialist area that offers further diversification and a bulwark against rising interest rates.” The fund has not been going long enough to have a dividend track record, but Starwood’s equivalent fund in the US paid over 7 per cent.
Emerging market corporate bonds
Emerging market corporate bonds are a relatively new asset class. Emerging market companies have historically had relatively little access to global capital markets, but as corporate governance has improved alongside the economic outlook for many emerging market countries, appetite has increased and emerging market companies have found themselves able to borrow.
Christy McKee, investment specialist at Legg Mason Asset Management, says the sector has grown phenomenally over the last three to four years and is generating increasing interest from institutional investors. In October last year, Thomson Reuters; data showed that a record $263bn worth of EM corporate debt hwas issued, a fifth higher than was issued in the same 2011 period.
The biggest surge in issuance has come from Latin America with groups such as state oil firm Petrobras leading the way. Other leading emerging market bond issuers have been Mexican firms PEMEX and America Movil, Chilean miner CODELCO, Brazil’s Banco do Brasil and Russia’s Sberbank also entered the list. Returns were in double digits last year.
Legg Mason is allocating more of its flexible bond strategy, the Legg Mason Global Multi-Strategy fund, to the asset class as liquidity improves and opportunities emerge. McKee says: “There are some really good opportunities with companies still coming to market on compelling yields. However, investors have to approach it on a country by country basis. In the Asian market, for example, there are not a lot of opportunities in high yield, but plenty of opportunities in investment grade. For the same rating there can be an 80-90 basis points up lift in yield. It is stock specific and it has to be bottom up.”
Groups such as Pimco and Aberdeen have also launched funds in this area. Pimco recently said in a note: “In our view, the risk profile for EM corporates has improved thanks to stronger sovereign balance sheets and economic growth prospects compared with developed markets.”
Emerging market government debt has already attracted a lot of interest, but this has also dampened yields. Emerging market corporate debt on the other hand still offers a higher income than developed market corporate debt, even though many of these companies are considered ‘investment grade’ by the market.
Pibs or ‘Permanent Interest Bearing Shares’ have proved a low volatility alternative to parts of the fixed income market. Doherty at Tideway has made good use of Pibs across his portfolios. They are issued by building societies and listed on the stock exchange. As such, they are relatively easily bought and sold. They still pay an attractive rate of interest, tending to offer a higher income than bonds or shares. They are exposed to the issuer going bust, but building societies have not historically been high risk businesses.
Most Pibs do not carry a maturity date. They simply offer to pay a fixed rate of interest forever. Interest payments are made gross and if the building society misses a payment, it does not have to pay out more for the next payment.
Sitting alongside Pibs are preference shares. This is a hybrid between a corporate bond and an equity and, as such, will often pay out a higher level of income than either. Some of the banking preference shares now pay out over 8 per cent. Investors are behind corporate bond payments but ahead of dividends in the corporate pecking order.
Ultimately, investors still have plenty of choice outside the mainstream equity and bond sectors. The real sacrifice made for higher income is liquidity, but this can be managed through the right structures. Equally, liquidity in many of these areas is improving. Investors just have to ensure that they are on the right side of liquidity. Increasingly, in corporate bonds, they may not be, but there are plenty of areas where they can benefit.
Equity income with growth?
It is accepted wisdom that income from equities comes from defensives – tobacco, pharmaceuticals or utilities. Yet, increasingly there are racier parts of the equity markets that offer the protection of a high and growing yield. Gone are the days when paying a dividend was seen as an admission that a company’s growth was over.
Europe – as prices of European shares have been pushed lower by concerns over the future of the eurozone, dividend yields have risen. Yields across Europe now match or exceed those of the UK, previously considered the high yield market of choice. France (3.6 per cent) and Germany (3.3 per cent) both pay equal or higher yields than the UK (3.3 per cent). Italy (3.9 per cent) and Spain (4.8 per cent) are higher still and this is even after the bounce in European stockmarkets since the start of the year. There is an increasing choice of higher income European-focused funds with offerings from Jupiter, Invesco, Allianz, Newton and Argonaut.
Frontier markets – frontier markets seem among the least likely places to find high yielding shares, but, As Sam Vecht, manager of the BlackRock Frontiers investment trust says, these countries have some of the higher yielding and fastest growing companies in the world. Corporate management in these countries increasingly recognises the need for international capital and international capital likes to get its money back through dividend payments. The BlackRock trust currently pays an income of 3.2 per cent and Vecht says this is a ‘natural’ yield – that is, he is not striving to pay a yield, it is simply a natural consequence of the companies he is buying.
Investment trusts – it is a bit of a cheat lumping investment trusts together as one, but it is more as a reminder that some of the major, mainstream investment trusts still offer very attractive and growing levels of yield. The City Merchants High Yield trust, run by Invesco’s Paul Causer & Paul Read pays 6.1 per cent and sits on a discount of 3.6 per cent. The Henderson Diversified Income trust, managed by Henderson’s John Patullo and Jenna Barnard pays an income of 5.9 per cent and sits on a discount of 7.7%. British Assets, managed by Phil Doel, pays 5 per cent and sits on a 4.7 per cent discount. Then there are also more esoteric trusts, offering quasi-property type returns, such as doctor’s surgery trust Medicx, paying 7.4 per cent.