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How to dodge the risks facing your income portfolio

08 July 2015

Fidelity’s Eugene Philalithis gives his outlook for income-generating assets in the midst of various global headwinds.

By Lauren Mason,

Reporter, FE Trustnet

Traditional income-producing assets such as government bonds, investment grade bonds and cash have lost their appeal in the hunt for income, according to Fidelity’s Eugene Philalithis, who warns the outlook surrounding perceived ‘safe havens’ is as murky as ever.

The FE Alpha Manager (pictured) instead believes that growth and hybrid assets offer the best opportunities in a macro environment where impending rates hikes from the Federal Reserve, alongside the continuation of the Greek crisis, are causing uncertainty in the market

While these assets are traditionally deemed as higher risk, Philalithis argues that ‘safe’ income investments are more likely to lose investors’ money.

“Traditional income assets continue to offer low yields compared to investment grade and high yield credit. They continue to offer an element of capital protection in a multi asset income portfolio but their low yields remain relatively unattractive for income-seeking investors at present,” he explained.

One of the major deterrents from investing in traditional bonds, according to the portfolio manager, is the impending rate hikes from the Federal Reserve.

If interest rates were to rise, the valuation of bond yields and cash lump sums are likely to depreciate, which is why many investors argue that higher-risk income assets will provide greater cushioning through higher yields.

What is unnerving investors even further is that nobody knows for certain when the Fed will hike rates – according to chair Janet Yellen, this will depend on the stability of markets globally.

The Fed has previously stated that US rate rises would be considered in view of the global outlook, and the risks posed by Greece as well as a strengthening dollar could lead them to hold off on interest rate rises,” Philalithis said.

“Indeed, as the Greek crisis enters a new stage and investors turn to ‘safe haven’ assets such as long-dated US treasuries and cash, the risk of a September rate rise is fading fast as both of the Fed’s conditions for delaying rate rises are coming into play.”

As such, Fidelity are currently using these assets as a means of risk control during volatile periods but are also open to opportunities that will provide a more desirable income.

“Of course, recent volatility in fixed income markets has reminded investors that no asset class is an eternal ‘safe haven’ and we continue to monitor market volatility carefully,” he added.

While inflation will cause many ‘safe’ assets to drop in value, there is also the risk that the economic growth rate could remain slow while commodity prices remain high, damaging the economy and leading to unemployment.

“Over the next few months, inflation is likely to become a more significant consideration for investors,” Philalithis explained.

“Any potential stagflation will also concern the Fed, should growth fail to pick up and inflation rise. Oil prices have recently stabilised and a pick-up in prices could have an important impact on inflation.”

“In this context, inflation-linked bonds can protect against any upside surprise in inflation for investors, though proper management is essential to ensure that their low yield does not drag on a portfolio.”


Not only do they hedge against the impact of inflation, inflation-linked bonds’ returns generally don’t correlate with stocks, therefore adding diversification to a portfolio.

Another factor impacting the portfolio allocation of the Fidelity Multi Asset Income fund is the increasing strength of the US dollar. While it has tailed off slightly over recent months, the dollar has strengthened substantially relative to the likes of the euro and sterling over the past year.   

Performance of currencies compared to sterling over 1yr

 

Source: FE Analytics

This could negatively impact income investors with global exposure by detracting from their overall return. What’s more, Philalithis expects the bull market to continue, as long as rate rises aren’t pushed back to late 2016.

“A strong US dollar has weighed on emerging market debt (EMD) in local currency terms in the last few months,” he said.

 Performance of indices over 1yr

 

Source: FE Analytics

“While this continues to be the case, markets did not seem to over-correct during the recent dollar rebound, which caused local EMD to retrace earlier lows, rather than mark new ones. Sell-offs appear to be over for now and if we see an improvement in EMD, it could be driven by China.”

Until recently, the Chinese market achieved a phenomenal performance, with the Shanghai Composite index returning more than 45 per cent from the start of the year to the end of May.

Performance of indices from Jan to end of May 2015

 

Source: FE Analytics

However, the soaring market proved unsustainable and the bubble burst, causing the index to plummet by 26.73 per cent over the last month alone.

While the Chinese government has taken drastic measures to prevent a stock market crash including suspending hundreds of Chinese stocks and encouraging China’s top brokerages to buy billions of dollars’ worth of shares, the market is continuing to spiral downwards.

As such, Philalithis believes that China’s structural reform, which was deployed to combat the slowdown in growth, will continue to remain volatile over the long term.

“Any major upside economic surprise from China in the next few months seems unlikely and a downturn could prove challenging for Asian equities as a whole, as well as for commodities.”

“But in light of China’s continuing economic slowdown, it is worth remembering that its shift to a more consumption-driven economy will be positive news for countries who can exploit this trend in the longer term, if not for countries that have benefited from massive commodity demand in the past,” he pointed out.

 Another fertile hunting ground for income manager is Europe, according to the manager, despite the headwinds which have plagued the market over recent months. 


“Greece is clearly a concern, but the ECB seems ready to ensure that contagion does not spill over to the rest of the Eurozone. In the weeks prior to the breakdown in the Greek negotiations, European PMI data pointed to strong growth for the rest of 2015, and this should not be too adversely affected by Greece,” Philalithis said.

“Recent European money growth offers support for equities and of these, we naturally focus on dividend-paying equities for their income.”

On top of that, while he admits that hybrid assets are sensitive to geopolitical risk and have therefore suffered a recent drawback, the manager believes that continued growth will stand the assets, which include bank loans and collateralised loan obligations, in good stead over the next few months.

“Similarly, the outlook for high yield bonds remains relatively positive, but while yields have risen (especially in Europe), high yield bonds still look slightly expensive for the moment,” Philalithis added.

Fidelity Multi Asset Income, which is £129m in size, has provided a total return of 38.63 per cent over five years, outperforming one of its benchmarks, the Bank of America Merrill Lynch Sterling Broad Market index, by 2.67 percentage points.

Performance of fund vs sector and benchmarks over 5yrs

Source: FE Analytics

However, it has underperformed the FTSE All Share and MSCI World ex UK indices by 22.46 and 39.72 percentage points respectively, due to its 63 per cent weighting in global fixed interest securities and an underweight 7.21 per cent in North American assets.

Fidelity Multi Asset Income has a clean ongoing charges figure (OCF) of 1.4 per cent and yields 4.19 per cent.
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