Income investing has just been getting harder and harder. The long-term downtrend in interest rates and bond yields means investors must be more creative and accept a higher level of risk to achieve income (or yield) close to 4%. We believe the Fed’s slightly more hawkish tone will make life a little easier, but not by much.
Go back to the late 1990s, when the Singapore government first started issuing bonds. It was relatively easy for income investors – the 10-year bond yield was hovering over 4% and therefore this could play a significant anchor role in any allocation, with other allocations – such as REITs – being used to ‘juice up’ the yield to over 5%.
Fast-forward to today and the 10-year government bond yield has collapsed to 1-2%. The picture is no different in the US or Europe.
This sustained decline in bond yields led us to launch our multi-asset income allocation in 2014. The aim was twofold – generate a yield of 4-5%, while still delivering positive total returns. Overall, this has been very successful – our USD-denominated allocation’s yield remains just above 4% and the allocation has generated cumulative returns of over 60% since inception.
However, it is getting harder and harder to meet the minimum yield requirement as asset prices rise and yields fall.
It is against this backdrop that we think, on balance, that a moderately hawkish Fed policy is good news.
Rising interest rates can lead to rising government bond yields, which in turn means falling bond prices. Nevertheless, rising yields is a double-edged sword once you factor in the reinvestment of proceeds from maturing bonds.
Let’s say you invest in a bond with a 5% yield. If bond yields rise, bond prices decline. While you may feel the pain of a short-term paper loss, you can take comfort that if you hold to maturity then 1) you should get your money back with interest (assuming no default); and 2) the yield at which you can reinvest your proceeds will be higher, helping you to achieve your longer term income goal.
Against this backdrop, we focus on three main areas of a diversified income allocation that are likely to be more resilient to rising bond yields.
First, high dividend paying equities, especially in Europe. Dividend yields in Europe are still very competitive and above the 4% threshold. Meanwhile, we believe there is scope for capital appreciation, given the strong economic recovery, the ECB’s recent regulatory relaxation on financial sector dividends, and a likely strong performance of some Value-style sectors such as energy.
Second, within bonds, we have a preference for the higher yielding areas of the market. Although higher valuations mean returns may be capped close to the yields on offer, we see scope for significant price returns in Asia sub-investment grade bonds.
Finally, we continue to like the so-called hybrid assets, which have characteristics of both bonds and equities for two reasons. One, their yields on offer are more attractive compared to other credit assets; and two, historically, hybrid assets, such as CoCos and preferred securities, proved to be resilient in an environment of rising interest rates and yields.
Among alternative assets, office REITs face greater uncertainty from work-from-home arrangements, though limited new supply of high-grade office space is supportive. Traditional retail businesses remain under pressure, while the structural shift to eCommerce and digitalisation has accelerated demand for logistics and data centres. Hence, our preferred areas would be REITs with exposure to logistics and data centre assets as well as industrial REITs that can benefit from a cyclical recovery.
Steve Brice is Chief Investment Officer at Standard Chartered Bank’s Wealth Management unit)
