Even over the long term, real interest rates aren’t expected to rise much above 1 per cent. So where may investors find income? James Foster and Jacob de Tusch-Lec, co-managers of the Artemis Monthly Distribution Fund, examine the opportunities
Last December, the Bank of England asked two big questions. First: how far have ‘real’ interest rates fallen worldwide? Second: how likely are they to remain anchored at their current depressed levels? In a working paper, Secular Drivers of the Global Real Interest Rate, it argued that long-term real interest rates worldwide had fallen by around 4.5 per cent over the past 30 years through a combination of demographic changes, shifts in saving preferences and a glut of ‘precautionary’ saving by emerging markets. It then offered this gloomy assessment:
“The global neutral rate may remain low and perhaps settle at (or below) 1% in the medium to long run. If true, this will have widespread implications for policymakers.”
This is not, however, a question of mere academic interest to central bankers. Savers looking for income are entitled to find the prospect of real interest rates fluctuating at or around 1 per cent over the long term disheartening. So if the Bank of England’s prognosis is correct, where may savers, investors and pensioners find income?
Real rates in advanced economies
Notes: Purple line shows the GDP-weighted average of 10-year sovereign yields for 20 advanced economies (G7, Australia, Austria, Belgium, Denmark, Finland, Ireland, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland). Grey line uses one-year ahead inflation expectations from Consensus Economics as a proxy for 10-year inflation expectations for each country (again GDP-weighted together). The blue line simply shows the difference – so this measure of real rates does not take account of changes in risk premia.
Source: IMF, DataStream, Consensus Economics and authors' calculations, courtesy of the Bank of England.
Government bonds may seem the obvious answer. Helped by quantitative easing and regulatory changes obliging banks and pension funds to stockpile them, they have produced exceptionally strong returns for more than a decade. But if government bonds are ‘safe’ in the eyes of regulators, their yields are between non-existent and negative and the prospect for further capital gains seems slim. Moreover, if the Bank’s forecast that real interest rates will fluctuate at around 1 per cent is correct, that implies a modest degree of monetary tightening from here.
Inflation has been falling for years, but one of the biggest drivers of this has been globalisation. Anti-globalisation trends are increasing; this will counter some of these deflationary forces. That would be bad news for government bonds, whose prices are attached, albeit elastically, to the market’s interest-rate and inflation expectations. Not only do government bonds not offer much in the way of yield, they must also offer a decent prospect of incurring a capital loss and potentially substantial losses after inflation is taken into account.
Where else might investors turn? Unfortunately, there is an abundance of crowded trades in any asset that produces income. Because US Treasuries are the world’s benchmark ‘risk-free’ asset, their mispricing causes other assets to be mispriced in turn. Investment-grade bonds have been among the chief beneficiaries of the ‘hunt for yield’ and, more recently, of direct buying by central banks.
Recent issues by Sanofi, a French drugmaker, and Henkel, a German manufacturer of detergent, both came at a negative yield. But the effect can also be seen in equity markets, where defensive ‘bond proxies’ – lower-volatility stocks whose reliable, coupon-like dividends make them an alternative to bonds – have been in great demand. Their share prices have been bid up to extraordinary multiples of underlying earnings and, while that bubble shows signs that it may be beginning to deflate, we feel it has further to go.
The road less travelled
To this point, those buying investment-grade bonds – and bond proxies in the stockmarket – have benefited from being part of a crowd. Not only have the vast flows into those assets driven capital values higher, they have suppressed volatility and so attracted more investors. Because some of these post-crisis trends have been in place for so long, they seem to have assumed an air of permanence. Prices in some parts of the bond and equity markets imply that investors believe bond yields will never rise. Our concern is that this complacency may be storing up dangers for all assets.
In equities, one of the worrying consequences of the overwhelming consensus in favour of bond proxies has been that their valuations (the multiples at which their share prices trade relative to their underlying earnings) have risen to extreme levels. When tobacco stocks in the US began trading on price-to-earnings (p/e) multiples of around 18x, they had probably become too expensive. Those multiples then increased to 20x – and then to 25x. There must be a possibility of a bubble in some consumer staples stocks.
Standing apart from the crowd
Given our worries about crowded trades in bond proxies and potential liquidity concerns surrounding investment-grade bonds, we believe it makes sense not to rely too heavily on either group of assets. While we have some exposure to both, given the threat of a disorderly retreat from crowded trades we believe it also makes sense to own assets that are less fashionable. Furthermore, investing in unloved and under-owned areas can often mean we receive higher yields.
In bonds, that means complementing our holdings in high-yield bonds with capital-contingent securities (generally shortened to ‘coco’ bonds). These are very junior bonds – so junior, in fact, that they can be converted into equity and their coupon payments are optional. At times, the market has acted irrationally in pricing cocos, leaving them trading on ridiculously high yields. It also means owning bonds issued by insurers.
At the moment, investors remain cautious towards insurers, mostly because lower interest rates are reducing these companies’ investment income. We believe this misses the important point that many insurance companies are improving their capital base. New Europe-wide solvency rules for insurers were introduced at the beginning of the year. They make comparisons easier and give us more comfort about the creditworthiness of these companies.
Another important area for the fund is the hybrid market. Their technical idiosyncrasies mean some investors remain wary of them. We believe this concern is misplaced. For as long as the underlying company is generating solid cashflows, its bonds will perform and, most importantly, provide a healthy income, which is our priority.
In equities, investing in under-owned areas means avoiding high-quality consumer staples and utilities companies in the US that trade on historically high multiples of earnings. Allied to this is our belief that maintaining a relatively high level of exposure to ‘value’ stocks can act as a helpful counterpoint to our holdings in bonds. If – or when – rates rise, bonds of every description will come under pressure. Value stocks, however, tend to outperform when economic growth is accelerating and interest rates are rising. So, in equities, owning value stocks rather than bond proxies provides a useful counterbalance to our bonds.
It may transpire that the Bank of England is wrong – and that real interest rates rise to a level such that cash is not just secure but also a useful source of income. That, however, seems unlikely. We therefore continue to seek monthly income across bond and equity markets without depending too heavily on the over-owned (and sometimes overpriced) assets that dominate some income funds.
THIS INFORMATION IS FOR PROFESSIONAL ADVISERS ONLY and should not be relied upon by retail investors.
The fund may invest in emerging markets. The fund may use derivatives to meet its investment objective, to protect the value of the fund, to reduce costs and with the aim of profiting from falling prices. The fund may invest in fixed interest securities. The fund may invest in higher yielding bonds. The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities. The fund's annual management charge is taken from capital.
The additional expenses of the fund are currently capped at 0.14%. This has the effect of capping the ongoing charge for the class I units issued by the fund at 0.89% and for class R units at 1.64%. Artemis reserves the right to remove the cap without notice.
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