Income is still out there: weighing up bonds + shares

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CONTRIBUTED ARTICLE by Damien McIntyre.* With interest rates hovering around historical lows globally, investor appetite for alternative income sources has markedly increased. In the current environment uncertainty is writ large; challenges come at investors from all angles – global and domestic, as well as longer term structural challenges.

Although the US Federal Reserve (the Fed) recently raised rates, interest rates in Australia are at an all-time low and, according to government rhetoric and the Reserve Bank of Australia (RBA) are heading lower. Low interest rates create a problem for investors, advisers and investment managers – how do we create sufficient returns and adequate income to meet investors’ needs?

In numerous cases, investors are going further out on the risk curve, taking on more risk than they usually would, to generate a nominal return to meet their income needs. This is particularly pertinent to retirees living on a fixed income. 

History tells us that the further investors push out along the risk curve, it’s all fine until it isn’t. A trigger event – such as 2007-2008’s global financial crisis – can bring markets to their knees. Those investors who have a greater exposure to risk are more likely to have a greater exposure to capital loss. 

Despite the $2.78 billion on deposit at the end of July 2019[1], investors are hunting for alternative sources of income. Are they looking in the right places?

Bonds aren’t necessarily the panacea

In early August, the yield on the Australian 10-year government bond fell below 1% for the first time. Although the price of those bonds would have risen, from an income perspective, an investor is being paid less than the average six month term deposit rate in return for locking their money up for ten years. 

Looking at the global developed government bond index, it has 8.3 years duration – that’s a significant amount of interest rate risk unless you have a liability to hedge. At the same time, the average yield is 0.94%. In essence, investors are being pushed out along the yield curve without being paid more to take the risk. Further, a sizable cohort of government bonds in the developed markets are not only at historic lows, they have negative yields; using bonds to provide income in this context is an interesting intuitive challenge.

High yield bonds, those with a sub-investment grade or no credit rating,are often offered up as an alternative source of income, and usually pay several hundred basis points more than cash investments. The lower the credit rating, the higher the risk and the more investors expect to get paid.

Unfortunately for investors, the profile of high yield bond indices currently share similar attributes with developed government bond indices – high duration, low yield vis-a-vie the risk been taken and a greater weight given to those companies carrying the largest amount of debt. Investors in traditional bond funds, whether investing in government bonds or high yield, are taking significant risk to earn an insignificant income.

So, can investors get income from bonds in this market? The short answer is yes – but less probable from a traditional bond fund or passive investment tied to a fixed income index. Instead, an absolute return approach, such as that used by Payden & Rygel, can be a better option in a low rate environment. 

Such funds arebenchmark agnostic, generally managed to a cash benchmark. The manager won’t passively adopt the largest exposure to the biggest debtor or adopt a long duration because that’s where the index is. Instead, the manager has the ability to ‘cherry pick’ the bond issues (and issuers) with lower duration (i.e. less interest rate risk), a better yield and which are best placed to deliver on each fund’s objective.

The power of dividends

Australian investors are well versed in receiving dividends – after all, our recent election was, in part, lost and won on the issue of franked dividends. Typically overweight domestic equities, many local investors are unaware of the dividend potential of investing globally. Dividends are important for two reasons – they provide income and stability. 

The saying “profits are a matter of opinion, but dividends are a matter of fact” encapsulate the reason that dividend paying companies tend to hold up well during uncertain times but may lag when PE growth dominates. 

A high number of uncertainties in the world’s geo-political environment – Trump’s trade war with China and threats of impeachment, Brexit, the impact of climate change – each has the potential to destabilise markets. It’s times like these that dividend paying companies come to the fore. Why? Profits are calculations based on a range of real and estimated data and have been known to be overstated; dividends are tangible, paid from corporate earnings. 

As such, dividend paying stocks can provide investors with tangible returns on a regular basis, irrespective of market conditions. Over the long term, companies with stable or growing dividends perform better and display less risk than those cutting or not paying dividends (figure one). Although some investors might be fearful of dividends being affected by market volatility, history tells us that dividends are, in fact, remarkably resilient in volatile markets.

Figure one: Growth and volatility – companies with growing dividends do better

Epoch Investment Partners’ global equity shareholder yield strategy focuses on companies paying out high levels of dividends. This has delivered investors an ‘unintended consequence’; the stocks Epoch own tend to experience less volatility than the market. Because the total return that these companies generate over time is more ‘front loaded’ than that of the average company, there is less uncertainty around it, and the price movements over time reflect that lower uncertainty.

Not all dividend paying companies – or funds – are created equal. Often when a company encounters some sort of downturn and its stock price falls, its yield will rise. But often the developments that led to the drop in the stock price will eventually force the company to cut its dividend, with a lag. Therefore, it’s important to invest with a manager that focuses on dividend sustainability, and whether those dividends can be increased over time. A share portfolio comprised of companies paying a sustainable and growing dividend will be better positioned to provide a consistent level of income and ride out challenges in the years ahead. 

In such an environment it’s time for investors – and their advisers – to look beyond the benchmark. While a benchmark might be a satisfactory compass, it doesn’t always provide a true guide forward. In the search for income, investments that eschew mimicking a benchmark index in favour of delivering positive outcomes for clients should be your focus.


*Damie McIntyre is the CEO, GSFM Pty Ltd.

This article was originally published in The Australian.