In a world where yields across the broad range of global asset classes have been driven to incredibly low levels in nominal terms (less so in real terms), the chase for yield has been an overwhelming recent characteristic of investment markets. 
The combination of a change of direction of policy rates and weakening of fundamentals in parts of the global economy is leading to signs of stress in parts of the credit markets.
As a result, we thought it would be timely to discuss where we think there are attractive income generating opportunities and what we are currently avoiding.
In the period through to summer 2014, yields were generally falling across the bond asset classes while equities and other real assets were performing strongly with yields supported by dividend growth.
Performance of indices since September 2014
Source: FE Analytics
Since then something has been changing: higher risk bonds have not been performing as well, with negative total returns and equities trading sideways.
There are a few ways of looking at this more recent trend. Has the impact of low rates and falling government bond yields become fundamentally less supportive of asset prices and hence, credit growth and the economy? Is the cause simply falling commodity demand or even the strong dollar?
In a way it is all of the above and a consequence of this is that higher risk income producing assets have recently been delivering much less attractive returns, whether it is riskier bonds, equities with less well covered dividends or those that have been increasing leverage to deliver earnings growth or share buybacks.
Defaults on high yield bonds have now started increasing, dividend cuts are starting to come through and worries about potential defaults in certain emerging markets are starting to rise.
Clearly, there are now far fewer safe yields available.
In fact, there is no such thing as a safe income. Clearly the very low yields on government bonds come with the risk of capital losses as interest rates and yields rise.
At the other end of the spectrum a continued economic slowdown will inevitably mean credit stress spreads beyond the areas where it is already being felt and the equity dividends which are being supported by debt start to be cut.
So it is more a question of “where is the attractive risk reward on a spectrum when risk is increasing everywhere?”
To us there seems little attraction across most of the bond spectrum. Longer dated government bonds offer the potential for significant capital loss, if yields continue to rise. At the same time they offer little in the way of yield to compensate.
Higher yielding credit appears to be fraught with danger, with much exposure to cyclical industries or highly leveraged borrowers and recent events have reminded investors how quickly things can unravel in this area.
The area for us which offers the most attractive risk/ reward in fixed income is shorter dated credit in companies which are less exposed to cyclical risk, such as those with more predictable revenue streams.
Another area which seems potentially relatively good value is bank credit where spreads remain elevated compared to pre- crisis levels, but the underlying banks are vastly better capitalised than at any time in recent history.
In many cases these banks are subject to high levels of government ownership and, hence, implicit support. However such a strategy, while apparently low risk, does not generate the income which investors have historically expected.
Less clear is yield from equities.
Certain high yielding parts of the market are clearly at risk of dividend cuts: resources is a case in point but all areas with high levels of leverage or cyclicality must be more vulnerable than at any point in the most recent past, so we have actively been avoiding these.
Performance of indices in 2015
Source: FE Analytics
At the same time certain lower yielding areas might also be vulnerable as global growth slows as high valuations make the pain of disappointment all the greater.
Again the better risk reward appears to be in the dull middle ground. Good quality consumer defensives have relatively predictable dividend-paying capacity and as ever pharmaceuticals appear to be safer sources of income.
It appears to be, yields on UK equities have in fact been rising but that masks the likelihood that many of the big dividend payers in the index have, or soon will, cut their dividend.
Finally there remains property. Clearly this industry is highly dependent on borrowing and has rents that are to a lesser or greater degree dependent on the health of the economy. In its favour, yields have not fallen anywhere near the amount that other lower risk yields have fallen.
Our conclusion is that in an increasingly uncertain environment there is no safe income available and each comes with a different set of risks.
We would favour the safety of a lower risk and hence lower yield in most asset classes, favouring high quality credit at the short-dated end and better quality dividend streams over high yield (junk) bonds and potential dividend cuts in equity.
The end result of this strategy is a lower current yield but potentially better capital preservation and more potential for growth in the longer term.
David Jane currently manages the CF Miton Total Return, CF Miton Defensive Multi Asset, CF Miton Cautious Multi Asset and PFS Miton Cautious Monthly Income. All the views expressed above are his own and shouldn’t be taken as investment advice.
