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Surviving the income drought

Whether you are a private investor, a pension fund, an endowment or an insurer, you can be forgiven for sometimes feeling that the search for income is a lot like looking for a needle in a haystack. It doesn’t have to be that way, but it’s hard to deny the scale of the challenge or the impact of the drought.

As we entered 2017, more than $10 trillion of bonds offered only negative yields, according to the financial services company Tradeweb. The hangover from the financial crisis, approaching a full decade ago now, is clearly still lingering. Global growth remains sluggish, and central banks across the world have stepped in to help prop up economic activity, but the resulting financial repression has made income yield a scarce commodity.

Governments will continue to need regular sources of funding or “income” to help meet their growing liabilities.

A glance at developed market government finances makes for pretty ugly reading as well. Mounting pension and healthcare liabilities mean that the situation will only get worst. Aging Western populations will conspire to make the asset/liability equation much more challenging to solve. Consequently, governments will continue to need regular sources of funding or “income” to help meet their growing liabilities. At the other end of the spectrum, individuals’ thirst for yield will increase as they are forced to take ever increasing responsibility for securing and managing their own retirement incomes. Companies and institutions don’t escape either – none more so than an insurer who is faced with heightened regulatory capital requirements, at precisely the point where low yields would suggest they should be looking to alternative sources of income.

All this is intended to offer a frank assessment of where we are today and why income, such a key part of investor’s needs, is so elusive.

But not all is doom and gloom. Indeed, today there are more sources of income than ever before. For example, the emerging markets bond universe has doubled since 2007, now standing at US$10.3 trillion. Until recently, other asset classes, such as litigation finance and catastrophe bonds, hardly existed at all, and were accessible to only the most sophisticated investors.

 

Diversify to survive1

By allocating across a broader mix of asset classes (alternatives), beyond traditional equities, fixed income and property, and combining them together in an intelligent way, investors can reduce risk and increase expected returns because the correlations between them and more traditional sources of yield are often low.

Catastrophe bonds and other insurance-linked securities2 are good examples of these types of investments. The market for catastrophe bonds has grown from under $1 billion in value outstanding in 1997 to more than $25 billion today according to data provider Artemis. Typically for these instruments, the risk of non-payment is based on issues occurring in the natural world rather than in financial markets. They are certainly not “risk free” but clearly are exposed to a very different set of risks. Using some of these alternative asset classes should reduce the volatility of the overall portfolio. In fact, if the asset classes are fundamentally sound, the more types one uses, the lower the volatility – all other things being equal. Aircraft leasing, peer-to-peer lending and global loans are other compelling opportunities. Of course, as ever, due diligence in these areas is key.

To varying degrees, more traditional asset classes such as equities, fixed income and property still have an important role to play. A healthy and balanced portfolio can include steady and meaningful dividend payouts from equities, as well as the asset-backed, but more illiquid, returns from property and areas of the bond market that offer relatively attractive yields.

 

Liquidity is great, but you do pay for it

Outside of diversifying, which is a fairly well understood notion these days (although the strategies and approach can be nuanced), there is another important factor to consider as part of how to solve the income challenge, and one that many overlook far too quickly: liquidity.

In a technology-led age of instant access it is easy to see why we obsess over the importance of liquidity. Having ready access to funds is a genuine priority, and one that many investors are hesitant to give up. However, there is a cost associated with it. Sources of return, whether income or growth, require investors to take on a degree of risk, traditionally measured by volatility. Rarely is liquidity risk given the same prominence or depth of thought.

Liquidity risk, tailored effectively, is something to be explored and will suit different investors at different times.

Liquidity risk, tailored effectively, is something to be explored and will suit different investors at different times. Ultimately, though, by taking a long-term view as defined benefit pension funds do, your portfolio has more chance to meet your overall objectives. On a deeper level than that, it makes sense to better coordinate short-, medium- and long-term cash flows, identifying when it is possible to accept some illiquidity within the overall portfolio, and thus harness the benefits associated with locking your money away for longer periods of time. It is worth taking the time to do so, as interesting asset classes such as private loans to infrastructure projects and to corporates can suddenly become available.

The message is not just an institutional one; even retail investors should take heed and consider whether they are prizing liquidity above everything else, including the likelihood of a decent return once markets recover. The exodus from UK property funds after Brexit is a good example. Investors who were quick to rush out of the door after the UK referendum vote on June 23 missed the bounce in returns that occurred almost immediately after.  The Towers Watson Illiquidity Risk Premium Index, which covers all asset classes, estimates that investors who are prepared to accept some liquidity are typically rewarded with between about 75 and 175 basis points.

We cannot pretend that the market environment is easy, and that yield assets are easy to come by. What we can do, however, is readjust our expectations and mind-sets around some long-held misconceptions. Liquidity can be our friend, and unfamiliar does not necessarily equal risky.

 

1Diversification does not ensure a profit or protect against a loss in a declining market.

2Insurance-linked securities (ILS) are financial assets, the values for which are driven by insurance loss events.

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