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Traditional sources of income have had a comfortable ride in recent years, but this year is likely to prove more challenging, writes Gavin Counsell.
Income investors have enjoyed an easy ride for much of the past decade as a result of the loose global monetary polices implemented by major central banks. This originally helped stabilise economies, and has now paved the way for robust and broad-based growth. It has also prompted a surge in the value of bonds and equities, in turn benefiting traditional income funds, which have been able to deliver both income and robust capital growth.
Figure 1: US equities reaching all-time highs, volatility at all-time lows.
Conflicting forces will hit markets in 2018, however, as central banks retreat from the bond purchase programmes that have seen trillions of dollars pumped into world markets since 2008, and look to hike rather than cut interest rates.
Positively for risk assets, the broad-based, synchronised upswing that began a year ago shows no sign of easing up, with above-trend growth expected to extend from the major G7 economies to the emerging markets in 2018. That should see global growth approach four per cent in 2018, the strongest pace since 2011 and consistent with a continued reduction in global slack capacity and increased inflationary pressures. Indeed, we recently raised our expectations for 2018, reflecting positive global consumer and business sentiment, limited private sector balance sheet risks and accommodative financial conditions.
However, many equity markets appear expensive by historic standards, trading on high valuation multiples. The price/earnings ratio on the S&P 500, for example, has moved up from just 14.87 in January 2012 to 25.06 at the start of 20181.
Similarly, credit spreads tightened across the board for much of 2017 with little differentiation of risk at a sector or security level. In many cases, absolute yields offer little protection from any credit spread widening, with the potential for negative total returns. For example, with the rapid fall in European investment grade credit spreads to below 100 basis points, together with an increase in interest rate sensitivity, index yields only need to widen by 20bps to result in a negative overall return, completely wiping out the income generated.
Meanwhile, the yield on European high yield bonds fell below that of treasuries of a similar maturity last August, another sign that valuations in credit markets are reaching excessive levels2.
At the same time, investors appear to be ignoring a number of threats to financial markets. These include the continuing build up in global debt, which hit a new record high of US$230 trillion during the third quarter of 2017, according to the Institute of International Finance (IIF)3.
“Even with low global rates, many non-financial corporates are running into trouble with debt service,” the IIF noted. It calculates that the percentage of “stressed” firms that cannot cover interest expenses has reached up to 25 per cent of corporate assets in Brazil, India, Turkey and China.
Many mature markets too have seen a rise in stressed firms, including Canada, Germany, France and the US. The IIF adds that as the Federal Reserve’s interest rate-tightening cycle continues, the risks are rising. Around US$1.7 trillion of emerging market bonds and syndicated loans are due to mature over the period up to the end of 2018, according to the IIF3.
Additionally, companies are accelerating the issuance of covenant-lite bonds, a trend that often occurs prior to a recession and reflects investors’ intense quest for income, which is luring them into riskier and riskier assets. Around 75 per cent of leveraged loan issuance is now covenant-lite, according to Thomson Reuters, up from a quarter prior to the global financial crisis4.
The covenant quality of North American high-yield bonds remained near its record-worst in November, according to Moody's Investors Service. The rating agency's Covenant Quality Indicator came in at 4.48. This is close to the weakest point on Moody's five-point bond covenant quality scale, where 1.0 represents the strongest investor protection and 5.0 the weakest point5.
The encouraging global growth outlook would suggest that investor sentiment should remain positive. But any shock to growth, even a minor one, could prove problematic for financial markets given that valuations are so high.
Upward pressure on yields
While economic growth should be supportive of risk assets, the fixed income sector is more challenged, with bond yields expected to increase as central banks look to normalise interest rates.
Unemployment rates in some economies, such as the US, the UK and Japan, are now below levels seen prior to the global financial crisis. Even allowing for the possibility that the equilibrium rate of unemployment may have fallen since 2007, these economies are likely to be very near to full employment. Meanwhile, the euro zone is likely to have relatively little spare capacity by the end of 2018. As the degree of spare capacity has eroded, with the expectation that inflation will rise, central banks have begun to embark on policy normalisation.
Arguably, euro-zone government debt is most vulnerable. Yields continue to be suppressed by European Central Bank asset purchases. However, with a likely end to quantitative easing in September 2018, we expect the market start to re-price from the middle of next year.
Figure 2: The withdrawal of monetary stimulus could pressure yields higher in 2018
So both the likely rise in interest rates and the withdrawal of monetary stimulus are likely to force yields higher.
Meeting the challenge
While having any general exposure to equities and bonds has worked really well for investors over the last few years, it would be dangerous to assume this will remain the case. For example, the US equity market (S&P 500 index) managed to deliver a positive return in every single month of 2017; the first time that this has ever been achieved. The S&P500 registered over 280 trading days without the price falling by more than three per cent in any one day, another record. Both achievements highlight the low risk world we have being living in.
Having access to a number of income sources, combining both traditional (e.g. equity dividends, bond coupons, property rental income) and non-traditional income sources (equity and currency options), should enable a portfolio to generate reliable and consistent income.
It is still possible to generate attractive levels of income without taking excessive risk. Take one example. Over the past few years Russia’s economy has struggled as a result of sanctions, but now fundamentals and growth are improving and inflation is stabilising. From a valuation basis, Russia offers attractive yields, making the overall thesis appealing. The traditional way to gain exposure may be via a direct investment in a Russian bond or via the currency. But this can also be expressed through a combination of derivative options on the currency; this strategy can enhance the level of income received, whilst reducing the maximum downside risk.
Careful portfolio construction can also enhance the overall investment outcome. The potential for rising yields is a particular threat to traditional income funds that invest in bonds for coupons. But is it possible to take positions that look to benefit from a rising yield environment. A focus on the US, UK and Japanese yield curves would be an example. In the US, the market is currently pricing little more than one more hike in the US in 2019, while we would expect two to three over 2018, and there is the risk of more. In Japan, we see the potential for the Bank of Japan to review its policy of yield curve control if core inflation rises above one per cent. Hence a portfolio should contain strategies that generate positive returns to mitigate this scenario, and provide protection for income generation.
So while this year could be another good year of growth, with reasonable returns from risk assets such as equities, there are some key challenges to traditional income portfolios. Therefore, it is important to have the flexibility to generate diverse sources of income while having the tools to protect portfolios against potential headwinds.
1 `S&P ratio by year`, multpl, January 2018
2 `European junk rally pushes yields below treasuries`, Bloomberg, August 2017
3 `Global Debt Monitor`, Institute of International Finance, January 2018
4 `Weak structures of cov-lite loans `, Moody’s, May 2017
5 `Covenant quality of North American high-yield bonds remains near record-worst in November`, Moody’s, December2017
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