A lot has been written about the historical low interest rates over the last decade. What is the significance of this trend for investors today, especially those with income generation as a primary objective?
Income-seeking investors are struggling to maintain the level of income generated from their investments as older bonds approach redemption and new bonds of comparable quality yield a third of the coupon on maturing bonds. So when deciding to reinvest one must compromise either the term to maturity or the credit quality of the contemplated investment. What are investors doing? And what alternatives are available in the market?
The answer to the first question has been evident and widely anticipated. As monetary authorities delved into quantitative easing policies, investors bought longer-dated bonds to benefit from the term premium and the higher capital upside as yields trailed lower. Yield-seeking investors switched to bonds of lower credit quality such as low-rated investment-grade bonds or sub-investment-grade bonds, also called ‘high yield’ or ‘junk’ bonds.
In recent years equity markets showed resilience to headwinds on corporate earnings in a challenging macroeconomic environment. Equity valuations soared to historical high levels due to capital flows to riskier asset classes. This shows that investors are climbing the wall of worry despite the uncertainty on the sustainability of the market rally.
Income investing has traditionally been associated with bond investing
But has this been a herd effect with little regard to the underlying fundamentals or is there a rational basis supporting this broad portfolio rebalancing? The risks of what can be described as a complacent market environment is that of overlooking the impact quantitative easing has had on depressing market risk premia. This calls for greater scrutiny of investment opportunities especially when the market is possibly on a path of slow normalisation.
Income-seeking investors now face the challenging investment decision – invest long or short? The biggest threat is an upward trajectory in bond yields as accommodative monetary measures gradually unwind and inflation expectations are slowly restored. Investing in short-dated maturities seems to be the more sensible option. But sub-one per cent yields on euro-denominated investment-grade paper with up to 10 years to maturity offer little appeal for income investors.
Diversifying out of euro could be an option, with relatively attractive yields on short-dated bonds found in currencies such as US dollar and Australian dollar. But this comes at the cost of adding foreign currency risk to the portfolio. However, would that be such a bad idea when considering upcoming events in Europe in 2017?
This year will see the triggering of the exit of Britain from the EU, and elections around Europe, notably in France and Germany. While the outcome of these events may not necessarily be negative for the euro, such foreign currencies stand to benefit in what could be a tumultuous year for the single currency.
High-yield bonds could also be an important component for investors as an income-enhancing asset class. By their nature, high-yield bonds have a shorter maturity and a higher coupon rate, which results in a lower sensitivity to movements in bond yields (also known as bond duration). The current slow growth and low inflation environment provides a favourable ambience for investing in such securities. Earnings outlook starts to ameliorate; default rates were benign even during difficult periods, while the low duration provides limited downside as interest rates start to rise.
Income investing has traditionally been associated with bond investing. However, stocks can also provide a steady income stream by paying regular and stable dividends. Picking dividend-paying equities has been a growing practice to enhance the income earning potential of a portfolio; especially considering the significant widening between dividend yields and bond yields. Investors would look for firms with strong corporate governance and a track record of converting stable earnings into dividends via an established payout policy.
The degree and scope of employing these income-enhancing mechanisms depend on investors’ risk tolerance. Cautious investors tend to maintain a home currency bias with limited exposure to high-yield bonds or equities. However, in an environment where the risks of rising interest rates are growing, a combination of these strategies stands to provide greater robustness in an investment portfolio while delivering on the objectives of income investors.
The information in this commentary is solely provided for information purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Matthias Busuttil is an investment advisor at Curmi & Partners Ltd.