Income Opportunities in a Low-Yield Environment

Rumour has it, that the low interest rate phenomenon which has dominated the portfolios of income seeking investors is here to stay. Global economic growth and inflation are two key economic indicators upon which central bankers base their case for lower or higher interest rates. In the developed world, banks’ interest rates have been on the decline for quite a while, mainly as a result of the global financial crisis and the lack of robust economic growth in the years that followed.

Among the largest economies, the US was the first to toy with the idea of higher rates as early as 2013 but only actually raised interest rates late in 2015. Following three years of steady interest rates hikes, 2019 saw a reversal of at least four of the previous hikes. This was the result of disappointing global economic data, uncertainty stemming from the US-China trade war, Brexit concerns and expectations that the global economy will go through some form of slow down.

Before moving on, it should be very clear that when markets are uncertain about the future or when growth expectations are gloomy, financial markets have a tendency to jump on high quality assets such sovereign bonds. This has been the case during 2019 and last January. Last month, fears that the coronavirus could be a global health concern sent investors seeking shelter in safe sovereign bonds.

The latter, as is the case with other fixed coupon assets, offer lower yields (income returns) every time the price of a bond moves higher, and vice versa. During the first month of the year, US 10-year Treasury yield fell from 1.9% to 1.5% while yield on similar maturity German bunds fell further in negative territory to negative 0.43%. High quality sovereign bonds, such as US Treasuries and German Bunds, set the stage for the pricing of other bonds, issued by both safe and high yield companies.

Due to the low interest environment we found ourselves in during the last decade, many investors have accepted miserable yields on their portfolio of high quality bonds. Even worse many other investors filled their portfolios with low quality high risk bonds. The latter strategy may have generated the desirable income but at the expense of higher portfolio volatility and higher risk of default. As a result we believe investors should be more prudent going forward. Judging the inclusion of a new security in a portfolio, solely on the basis of the income it generates, is a thing of the past. With income returns on high yield bonds having declined dramatically, investors might be exposed to unwelcome surprises when the next economic downturn occurs.

Having said that, we are not in favour of investors accepting very low yields on high quality sovereign and corporate debt. However, we do have a preference for actively managed strategies with exposure to varying sub-asset classes within the fixed-income universe. This means that investors can generate superior returns through a well-diversified bond portfolio which is actively managed and exposed to different bond qualities. Such a portfolio will have exposure to both high quality and risky bonds, but definitely not fully invested in anyone of the two extremes.

I am stressing the term ‘actively managed’ because of the pitfalls that investors find themselves in when investing in bond exchange traded funds (ETFs) which are non-actively or passively managed investments. When investors buy bond ETFs which are market weighted, they are simply allocating more money to the most indebted issuers. In other words, a company with high levels of debt will feature among the top holdings in that passive investment, hence exposing investors to higher levels of market fluctuations when things turn sour.

Unlike equity ETFs, it is very difficult to replicate a bond index. As a result, bond ETF providers often use a sampling method to copy the performance of the main index constituents. Therefore, these product providers do not buy the full range of bonds in the index. Most often, this is a result of the lack of liquidity in the bond market. Recent research shows, that two main high yield ETFs underperformed their benchmark on a five-year basis both in terms of annualized returns and volatility. In other words, the high yield bond ETFs recorded lower returns with higher risk.

Active managers in the equities space have struggled to beat the benchmark in recent years. On the other hand, active managers in fixed income have shown an ability to outperform their benchmarks. The huge size of the bond market and its inefficiencies are two main reasons why active bond managers have managed to beat their benchmark. Active managers can participate in the new issues market, where sometimes bonds can be bought at a discount compared to market prices.

The current low yield environment, which is very likely to persist in the years to come, will make it even more difficult for fixed income investors to generate decent yields from their good quality bond portfolio. We are strongly against heavy exposures to the risky part of the credit market. In addition, investors should more than ever before measure the performance of their bond portfolio on a total return basis and not just on income generated. That is, both income and capital should be considered when measuring how their portfolio has performed over a particular time period. Active management should be able to generate excess returns, which in turn will boost investors’ future income.

Gabriel Mansueto is Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]