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September 19, 2017

Building an income portfolio

By Mike Brooks, Head of Diversified Multi-Asset

Income investing used to be boring. Portfolios were built from bonds and from the most unexciting and dependable areas of the equity market.

No longer. In recent years, a combination of ultra-low interest rates and quantitative easing have pushed government bond yields close to – or even below – zero. Future returns from sovereign bonds and low-risk investment-grade corporate bonds look set to be low. Meanwhile, equity markets have reached record levels and now look expensive, indicating that their returns will also be muted. And with political volatility in the developed world and geopolitical instability in the Middle and Far East, there is potential for dramatic market reversals. As returns from bonds and equities have been shown to move in the same direction most of the time, they provide little protection from market downturns.

Bonds and equities still have a place in an income portfolio, of course. But income-seeking investors now need to look at asset classes that they would not have considered – or even known about – in the past. Beyond the traditional asset classes of bonds and equities, a broad range of alternatives offer compelling yields and considerable diversification benefits.

In our multi-asset income portfolios, we invest our clients’ money across a diverse range of ‘alternative’ investments. These include emerging-market bonds, high-yield bonds, absolute return, private equity, corporate loans, insurance-linked securities, infrastructure and peer-to-peer lending.

Some of these ‘alternatives’ have become increasingly mainstream, with hedge funds and private equity now common to many portfolios. These assets tend to be positively correlated with equity markets, however, and thus unlikely to provide significant protection when markets sell off. So we have developed specialist capabilities in several of the more esoteric asset classes.

These markets can offer attractive yields. And many have low correlations to bonds and equities. But besides their attractions, they offer specific risks. And their relative and absolute attractions can vary over time. So a crucial aspect of building an income portfolio is ensuring that there is appropriate diversification among them – thus reducing risk – as well as a focus on the highest-quality opportunities within them.

Many of these opportunities have specific attractions beyond their yields. Corporate loans, for example, offer the opportunity to receive higher returns as interest rates rise. This is because corporate loans aren’t fixed-income instruments but instead have floating-rate coupons – so the holder gets more income as yields rise. With the US Federal Reserve having raised interest rates twice this year already, this is an increasingly important consideration in the construction of an income portfolio.

Insurance-linked securities, sometimes known as ‘catastrophe bonds’, also hold considerable attractions. These securities pay investors a regular premium for taking on some of the risk of losses arising from specific events – such as damage caused to property by hurricanes, for example. The bonds fall in value if such events arise, but the declines do not mirror the equity markets; natural disasters are not correlated to economic recessions.

We also invest in infrastructure. Cash flows from infrastructure projects do not tend to change significantly with the economic outlook, so their returns are uncorrelated to those from bond and equity markets. Renewable infrastructure is a particular area of interest here, as governments worldwide are seeking to increase investment in sources of renewable energy. As state funding is struggling to provide the required capital, investment funds are stepping in to oversee renewable-energy projects. Although infrastructure investments are highly illiquid, their cash flows do not tend to change significantly according to the economic outlook, so returns from this asset class are uncorrelated to those from mainstream bond and equity markets.

One relatively new asset class is peer-to-peer lending. This allows investors to lend money to individuals or businesses. Peer-to-peer lending companies operate online ‘platforms’ that match potential lenders with borrowers. Unlike banks, the platform operators don’t make money from the spread between the lending rate and the borrowing rate. Instead, they charge fees for arranging the loans. For lenders, the returns look attractive – especially in an environment of low interest rates. At present, the gross rate of interest (before service fees and losses from defaulting loans) is typically in double figures. That could change if credit conditions were to deteriorate as they did during recent financial crises. Nevertheless, investors could still expect to achieve positive, if modest, returns in such circumstances.

Given the different attractions and risks of these asset classes – and the variety of opportunities within them – achieving and maintaining an appropriate balance of exposures is a key consideration. We’ve come a long way from a simple blend of equities and bonds, but we believe that the genuine diversification achieved through a broad range of alternative assets will be vital in the years and decades ahead. And it’s certainly never dull.

Mike Brooks, Head of Diversified Multi-Asset

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

Important information

The above marketing document is strictly for information purposes only and should not be considered as an offer, investment recommendation, or solicitation, to deal in any of the investments or funds mentioned herein and does not constitute investment research as defined under EU Directive 2003/125/EC. Aberdeen Asset Managers Limited (“Aberdeen”) does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document and expressly disclaims liability for errors or omissions in such information and materials.

Any research or analysis used in the preparation of this document has been procured by Aberdeen for its own use and may have been acted on for its own purpose. The results thus obtained are made available only coincidentally and the information is not guaranteed as to its accuracy. Some of the information in this document may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies. These statements are only predictions and actual events or results may differ materially. The reader must make their own assessment of the relevance, accuracy and adequacy of the information contained in this document and make such independent investigations, as they may consider necessary or appropriate for the purpose of such assessment. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither Aberdeen nor any of its employees, associated group companies or agents have given any consideration to nor have they or any of them made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document. Aberdeen reserves the right to make changes and corrections to any information in this document at any time, without notice.

Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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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