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 have grown increasingly expensive.
Diversification
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.
There are 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 are generating.
Now is not the time to be maximising 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.
It continues to be a positive landscape for the global economy and risk assets, and an environment of gradually rising rates, but it pays to be watchful for signs of exuberance and crowding. The late cycle environment favours broad exposure to equities over traditional fixed income. At the headline level, our level of risk appetite remains roughly the same as it was for much of 2017.
As income investors, equities with the ability to grow their income stream are particularly in focus. Dividend-yielding equities with the potential to provide capital appreciation as well as grow their dividend stream through time look attractive.
European equities also offer a diversified stock selection opportunity. Some managers are trimming their exposure to global equities slightly where more capital is being returned via buybacks rather than dividends.
The outlook for emerging market equities is constructive and they increasingly merit more of a place in balanced portfolios. It is important globally across equities to seek 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.
Key points
- Valuations today are looking stretched in some parts of the market
- European equities could offer a diversified stock selection opportunity
- High-yield debt is looking slightly less compelling as value in the asset class has been eroded
Preferred equities
Another attractive asset class 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. Using extensive security selection analysis, you can find attractively high yields and to manage duration exposure in this allocation.
