The need for a diversified approach in a low-yield world | Pensions - Aberdeen Asset Management
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September 20, 2017

The need for a diversified approach in a low-yield world

By Craig Mackenzie, Senior Investment Strategist

For decades, income investors have relied on government bonds and investment grade corporate bonds as the mainstay of their income portfolios. These assets have provided a relatively high income: a typical UK gilt index has offered an average income of 5.3% over the last 20 years. These bonds are relatively low risk, which is also an attraction for risk-averse income investors.

But during the last few decades, bond yields have declined steadily – as the chart below shows. Hitherto, this has not been a problem for investors. While the income provided by bonds has declined, this has been handsomely offset by the boost to capital return as yields have fallen (yields and prices always move in the opposite direction).

Lower Interest Rates – 10-year nominal yields (%)
2
Source: Oxford Economics, February 2017. Note: Chart shows yield on 10 year maturity government bond in each country.

Unfortunately, now that yields are close to rock bottom, the income return bonds offer is very low – but with little prospect of capital gain to compensate. So our expected total return for a standard UK government bond index is just 1% per annum for the next 10 years. The picture is not much better for investment grade corporate bonds (2.8% pa).

We suspect that while yields might rise a little, they are likely to remain unusually low for an extended period. This is because today’s low interest rates are a function of a global ‘savings glut’ caused by slow-moving demographic trends. Eventually, these trends will reverse, but not any time soon. Accordingly, low government bond yields will probably be with us for some time.

Rather than accept a low income from government bonds, many investors have sought yield from riskier sources of income like high yield bonds and high-dividend equities. Such assets can offer higher incomes, as the table below shows. It is a strategy that has worked well in recent years, with capital appreciation adding to income to generate good returns. But equities and high yield bonds are relatively risky assets whose returns are also highly correlated (i.e. they tend to fall in value at the same time). So this approach is not ideal for more risk-averse investors, particularly now that equity and high yield valuations are looking stretched.

Many investors may be better served by diversifying their portfolios across a much wider range of ‘alternative’ income sources.

This serves three purposes. First, the income available from these alternatives is often higher than that offered from equities and high yield bonds; second, investors can rotate away from high yield and equities when they are expensive; third, the underlying cash flows that drive these alternative sources of income have a low correlation with one another (unlike equities and high yield bonds). If one asset class crashes, the others may not be as badly affected. This means that by combining several diversified sources of income one can achieve a lower overall volatility.

What are these alternative sources of income? There is a wide variety: emerging market debt (EMD), social and environmental infrastructure funds, asset-backed securities (ABS), insurance-linked securities, litigation finance, health care royalties and many more. Our three largest portfolio allocations are to EMD, infrastructure and ABS.

Income return: forecasts vs history

  3 year forecast Historical average Difference
UK Gilts

1.9

5.3

-3.4

Global govt bonds

1.5

2.9

-1.4

UK Investment grade bonds

3.9

5.9

-2.1

Global investment grade bonds

4.1

5.2

-1.1

UK cash 3M LIBOR

0.5

3.7

-3.2

US High yield bonds

6.5

8.5

-2.0

Global equities

2.4

2.3

0.2

EM Debt (hard currency)

5.9

6.0

-0.1

EM Debt (local currency)

6.1

7.1

-1.0

Senior secured loans

5.8

5.8

0.0

UK infrastructure social

4.6

5.1

-0.5

UK infrastructure renewables

5.6

5.4

0.2

Asset backed securities (mezzanine)

4.5

5.0

-0.5

July, 2017. Historical averages are based on 20 year histories where available. Income forecasts are based on house long-term expected return models. Total returns are often different from income returns because changes to capital values can add or subtract return.

Emerging market local currency debt. These are bonds issued by emerging market governments in their local currencies. Yields are much higher than in developed markets, currently averaging 6%. While there have been defaults in the past, lessons have been learnt in recent decades and these bonds are now safer. Our approach is to hold bonds issued by more than a dozen different governments, and this further mitigates the risk.

Infrastructure funds. These funds own social infrastructure assets (such as schools and hospitals) with government-backed inflation-linked income, or renewable energy assets (such operational solar or wind farms) that earn a reliable cashflow stream from a mix of government subsidies and power contracts. These funds have proven to be resilient in volatile equity markets.

Asset-backed securities. These are pools of securitised mortgages and corporate loans. ABS offers higher yields than corporate bonds of the same credit quality, with a lower volatility and lower risk of default.

By combining a range of these diversified income sources with more conventional income assets, this approach can generate an income of around 5%. This is a fair bit higher than the traditional bond-based income portfolio of government bonds and investment grade credit. But volatility, on the other hand, is only a little higher. In an age of low government bond yields and expensive equities, we think this is an attractive proposition for income investors.

For more information on Aberdeen’s long term asset allocation forecasts see chapter three of Aberdeen’s 2017 Long-term Investment Outlook

Craig Mackenzie, Senior Investment Strategist. Craig leads on Aberdeen’s long-term strategic asset allocation research.

 

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Risk warning:

Risk warning

The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.

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