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Schroder’s Forest: Investing for income in a low growth world

Aymeric Forest

The ‘traditional’ way to earn income has been to hold government bonds or money market instruments. In this economic environment these no longer provide an answer, as they do not give a high enough yield, either in inflation-adjusted or absolute terms.

Since 2007 government bond yields have dropped to levels unseen since the Great Depression. In addition, very low interest rates and quantitative easing, combined with risk-aversion and the poor outlook for growth, have contributed to the falls in government bond yields.

With slowing economic growth, capital gains from investments will be harder to find and will come at a greater level of risk. With yields from traditional sources falling and risk rising, investors need to maximise their opportunities and diversify.

The economy is vulnerable to shocks and any single asset class is likely to suffer from a higher level of systemic risk. A multi-asset approach delivers an improved risk/return trade-off in comparison to holding each asset class on its own.

It can take advantage of a wider range of income-generating asset classes – not just the traditional government bonds or money market instruments. This includes higher yielding equities, infrastructure and different types of bond, such as investment grade and high yield debt, emerging market debt and municipals, from around the world.

A benchmark-unconstrained approach means taking advantage of yield opportunities in whichever region or sector they arise, without having to hug a given multi-asset benchmark.

It is important not to chase the highest yields, but look for sustainable income. In this environment, what matters is not only the promise of a future yield but the probability of default on the payment of a coupon or a dividend cut.

One way of managing risk is to ensure that the portfolio is diversified and not overly concentrated in companies, industries, currencies, countries or asset classes.

High-dividend companies tend to be concentrated in sectors such as telecoms or financials, or in countries such as Australia and the UK.

Sometimes diversification is not enough and you need to be able to dynamically hedge unwanted sources of risk. This can include hedging duration and equity market risk.

The evolution of downside risk management techniques and derivative instruments enables the astute investor to have access to the required income while ensuring the capital is protected.

Income investing is not new. What is new are the challenges faced by investors in creating a portfolio with the right level both of income and risk in this low-yield, low-growth and high-volatility world.

Yet the demand for income-generating asset classes and solutions is increasing. Investors are aware that the only chance to achieve their objectives is to take more risk, but that this increases the probability of capital erosion. This is why managing risk and avoiding drawdowns is as important as finding income.

The best strategy for a positive return and a high income is to combine unconstrained security selection focused on sustainable yield with a dynamic risk management focused on diversification and capital preservation.

Aymeric Forest is a fund manager in Schroders’ multi-asset investment team

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