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the times they are a changin

The times they are a-changin’

  • 11May 16
  • Richard Dunbar Senior Investment Strategist, Investment Solutions

Generating income has always been an important consideration for investors. But the way in which income is generated has changed a lot in recent years.

In the income world twenty years ago we really just had equity income portfolios and bond portfolios, while a small number of ‘managed income’ funds sat in the middle. Equity folk ran the equity funds, bond folk ran the bond funds, while the managed income funds tended to have a relatively fixed 60:40 allocation between equities and bonds. Over time these strategies didn’t work too badly.

Equity income proved a good “style”. It tilted investors towards companies that generated cash, and ones that had management teams with the discipline to pay some of that cash out to shareholders in the form of dividends. The kind of portfolios created had a leaning towards “value” – a style that over the long term has been conducive to wealth creation.

The bond funds also did what they were meant to, providing a decent income by investing in relatively low-risk government bonds and investment grade credit.

The ‘managed income’ funds were also OK. However, it would be fair to say, that with their 60:40 split they looked much like the traditional balanced fund; they were not particularly dynamic, and thus engendered less investor interest than their single asset-class peers. Ultimately, clients decided to make their own asset allocations between equities and bonds.

But how has the investment landscape changed over the past couple of decades – and how has this affected income strategies?

First, we have had a roaring bull market in government bonds over the past twenty years. US Treasury yields have fallen from 14% in the early 80s to a paltry 2% today. The collapse in the yield provided by this bellwether asset has highlighted the need for investors to hunt for income. This move has been mirrored in most other developed-bond markets. In fact, large swathes of the government bond market now offer the less-than-enticing prospect of negative yields.

However, as the attractions of the traditional government bond markets for income investors started to wane, a myriad of other bond markets have become more accessible, acceptable and tradable. Hence, the last few years have seen the expansion of the investment grade credit markets – aided and abetted by a banking sector desperately trying not to lend any money. We have also seen the return and expansion of the high yield market and the arrival of more liquid and better regulated emerging market debt markets. All these areas offer good investment opportunities, and more often than not a higher yield along with levels of liquidity and regulation that weren’t available even a few years ago.

In the equity world, there have also been some key developments. The global financial crisis was not kind to dividends. In the UK for example we lost almost one third of all dividend payments, as the recession hit all companies, but particularly the dividend-rich financials. However, my belief that dividends, and the management discipline to pay them, tells one something about the quality of the company in which you are invested does appear to be catching on. Hence in Europe and in the United States dividends have become increasingly de rigueur. And even in Japan, not previously thought of as a happy hunting ground for income investors, dividends are now seen as part of the evidence that companies are more focused on their shareholders – wonders never cease. The net result of this increasing enthusiasm is more opportunity and, as in the bond world, more levers available should one feel able or willing to pull them.

“We now have income opportunities in insurance-linked securities, litigation finance, aircraft leasing and peer-to-peer lending, to name but a few.”

But some of the greatest changes in the income world have been in the number of new investment options by which one can produce income. Markets have responded to the lack of income available elsewhere and supplied products to meet this demand. Hence we now have income opportunities in insurance-linked securities, litigation finance, aircraft leasing and peer-to-peer lending to name but a few. Some of these are markets that have been around for a while, others are relatively new. But all now are markets where it is possible to invest directly or through the use of dedicated funds. Again, there are many more levers to pull, should one have the ability or inclination to do so.

The other major change over the past couple of decades is that investors have adopted a much more sophisticated and holistic view of the world. From the rather siloed environs of the equity manager and the bond manager twenty years ago investors now have much more sophisticated multi-asset tools that should allow them to be better at judging the relative merits of the various opportunities that they have in front of them. The related advantage of this much more sophisticated approach should be better diversification, given the range of assets available and the more advanced risk tools now at investors’ disposal.

Of course, opportunities will continue to ebb and flow – income opportunities within US Treasuries have rarely been worse, while income opportunities among Japanese equites have rarely been better. That’s the nature of markets and cycles. But whatever the current point in the cycle, I don’t think that there have ever been more choices available to income investors.

Finally, and obviously, none of the above developments preclude the requirement to do one’s homework. Buying assets “just for yield” or “just for diversification” leads one several steps down the road to penury. With greater investment opportunity comes an even greater requirement to thoroughly study the assets themselves and focus on the risks that appear when these assets are put together.

Income investing has come a long way in my time and it has never been more exciting. In a world where more investment responsibility is being passed on to individuals from the state or employers, it is a strategy that is increasingly important for everyone to consider. I look forward to seeing what the next twenty years bring.

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