The ongoing search for income in a market where yields have been pushed down has led investors to riskier assets, but strategists at JP Morgan Asset Management believe there are ways to reduce that risk.
The income that can be generated from cash and government bonds – seen as the safest parts of the market – has been significantly reduced over the past decade by historically low interest rates and massive quantitative easing programmes.
JP Morgan Asset Management global market strategists Michael Bell and Maria Paola Toschi said this low-yield world is expected to persist for some time given the dovish stances of the US Federal Reserve and the European Central Bank.
“This low rate environment creates a now all too familiar dilemma for many investors who need an income from their savings,” they said. “They either have to accept a much lower income than they were used to prior to the global financial crisis, when interest rates were higher, or they have to take more risk to earn a higher income from their investments.
“This dilemma becomes even trickier the later we move into this economic cycle, as the rising risk of a recession increases the potential for declines in stock and corporate bond prices.”
While the risk associated with higher yielding investments cannot be eliminated, Bell and Toschi argued that can be reduced. Below, they highlight three ways investors can seek out a higher income and keep an eye on risk in a low-yield environment.
Think in decades, not days
The first strategy is one that many investors will already be aware of: adopting a long time horizon for investments and use this as a way to reduce risk.
Income yield and range of asset class returns
Source: BAML, Bloomberg Barclays, FTSE, Refinitiv, Datastream, JP Morgan Asset Management
“If you accept that it’s hard to precisely time the peaks and troughs of the market cycle, but that over the long term the global economy and company earnings are likely to keep growing, then riskier investments can make sense as a long-term investment – even towards the end of an economic cycle,” Bell and Toschi said.
The strategists explained that this essentially means investors buy and hold on to investments for the long term and ignore swings in their value as long as they continue to receive an income; this approach allows them to take more risk and pursue a higher income.
Be selective
If investors are able to maintain long-term mindset, then the next consideration should be looking at the sustainability of the income produced by a given asset.
“Some companies might pay a high dividend but have to cut their payout when profits fall during a downturn. Likewise, some companies might pay a high income in return for lending to them, but they may be unable to pay you back in full when profits fall,” Bell and Toschi added.
“Some governments might even fall into this latter category, or at least they might struggle to pay you back in a currency that is worth as much in real terms.”
With equity income, the JP Morgan strategists noted that it is important to consider dividend coverage ratios and the sustainability and cyclicality of the company’s profits, in addition the more commonly-used metric of yield.
Dividend coverage ratios can indicate which companies are more resilient to having to cut their dividends if profits fall (the higher the ratio the better).
FTSE All Share earnings and dividends per share
Source: Factset, FTSE, JP Morgan Asset Management
The sustainability and cyclicality of corporate earnings also allow the investor an insight into the likelihood of a company being hit by falling profits and having to take another look at their dividends.
Likewise, corporate bond investors have to pay attention to interest coverage ratios, which are a measure of profits divided by interest payments rather than dividend payments. The sustainability and cyclicality of earnings are also essential when considering whether the company will still make payouts during a recession.
“The key for investors who need an income from their savings and can take a long-term investment approach, resisting the temptation to sell during a downturn, is to buy the debt and shares of companies that are able to keep paying you dividends and interest payments, even during a recession,” Bell and Toschi said.
“Importantly, it’s not just a matter of picking the debt and equity of the highest yielding companies but carefully selecting the highest yielding companies that can keep paying you that yield.”
Expand your horizons
The third strategy for investors looking to maximise both yield and diversification is to seek the widest opportunity set possible – while remaining selective and only choosing investments that can reliably pay out income.
“A global approach allows the portfolio manager to select the most reliable income payers from across the whole world. A cross-asset approach also helps to expand the opportunity set to a larger amount of income-producing investments,” the JPM Morgan strategists said.
“Investors should consider the yield available on a wide variety of assets from all over the world, taking into account hedging costs to reduce currency risk where appropriate.”
One example is high yield corporate bonds, which currently have low default rates and could offer opportunities for selective long-term investors.
Asset class yields
Source: Bloomberg Barclays, BAML, FTSE, MSCI, ODCE, Refinitiv Datasream, Standard & Poor’s, JP Morgan Asset Management
In addition, while many income investors have concentrated their efforts on the developed world, Bell and Toschi pointed out that emerging markets “can be a fertile hunting ground for income”.
Many emerging market companies are now more focused on corporate governance and distributing cash to shareholders in the form of dividends.
Meanwhile, there are opportunities with differing risk/reward profiles in emerging market debt. For example, local currency sovereign bonds in some emerging markets offer high real yields when compared with developed market government bonds – which in some cases have negative real yields.
“Away from high yield bonds, emerging market debt and equity markets, investors should also consider the steady and relatively defensive income streams available from real estate and infrastructure investments,” Bell and Toschi concluded.