Building better income portfolios

As finding attractive sources of income is proving to be more and more difficult in the current low cash yield environment, Jon Howie looks at why a multi-asset approach is the way to generate income.

Whether it is an actively-managed option, a portfolio built entirely with exchange traded funds (ETFs), or an approach that combines both, there is a range of alternatives available to assist in building better income portfolios for your clients.

As yields from cash and government bonds remain at near historic lows, the search for income is a top priority.

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In this environment a multi-asset approach is one of the best ways to generate a good level of income.

Portfolio construction is moving away from the traditional ideas of a balanced mix of equities, bonds, and term deposits, and advisers are increasingly casting a wider net while carefully balancing the trade-offs between yield and risk.

Striking a prudent balance between income and risk increasingly requires a combination of traditional and non-traditional investments.

Nevertheless, finding attractive sources of income is no longer as easy as it once was. The universe for yield has shrunk.

Traditional fixed income yields are on average less than half their pre-global financial crisis (GFC) levels.

Today, investors need to take greater levels of risk to achieve the same returns of years past. For those concerned with capital preservation, this can be an alarming prospect.

The question for advisers is how can they construct portfolios to meet the dual income and risk requirements of their clients. In 2007, most global fixed income yielded over four per cent per annum.

Today, it is closer to just 20 per cent yielding over four per cent per annum.

It is important to be mindful of where you seek yield, particularly if capital preservation is a portfolio objective.

When we think about how clients have accessed income in the past, one of the most popular investments for Australian investors has been equities.

While Australian equities continue to provide potentially attractive income from dividends, the performance of that asset class - particularly for those investors focused on income rather than long-term growth - has been challenged over the past year or two.

Australian equities are not a one-stop shop for an income portfolio and it is important to consider how to incorporate diversified sources of return into a portfolio of Australian equities.

This is particularly relevant when you consider that the sustainability of future dividends is under question, and there is also a concentration risk to consider.

For instance, the top five stocks on the ASX represent around 30 per cent of the S&P/ASX 300 market capitalisation and four of them are banks. Perhaps more importantly, they provide around 40 per cent of the overall yield.

This is not a diversified option and there is significant risk in being overexposed.

But a flexible approach can help balance the trade-offs between yield and risk.

Today, diversification can't just be considered in terms of asset class, it also needs to be considered in terms of risk factors.

This is in no way suggesting that income seeking clients shouldn't continue to invest in Australian equities, but by investing in a more diversified portfolio, they can enhance yield and decrease volatility.

For instance, consideration can be given to enhancing a portfolio's income potential with a comprehensive mix of non traditional asset classes, including high yield, emerging market debt, investment grade corporate bonds, as well as the traditional options of equity dividends and Australian fixed income.

High yield

One of the highest-yielding sectors in the global fixed income universe is high yield bonds.

They can offer attractive potential for income generation as part of a diversified portfolio.

What's more, high yield (as represented by Barclays Capital US High Yield Index) has historically outperformed other fixed income assets - treasuries (as represented by Barclays Capital US Treasury Index) and bank loans (as represented by S&P Leveraged Loan Index)- in periods of rising interest rates.

Corporate fundamentals have been supportive of high yield as solid earnings have allowed companies to reduce borrowing levels and maintain comfortable levels of interest coverage.

The low interest rate environment has enabled many to refinance their debt at very low borrowing costs and with long payment horizons.

Emerging market debt

Emerging market debt currently provides some of the highest yields in the fixed income universe: higher than similarly rated corporate debt in developed economies.

US dollar-denominated emerging market debt, for example, yields well above six per cent despite being around two-thirds investment grade-rated.

Investment grade corporate bonds

Corporations have taken advantage of the low interest rate environment, not just issuing more bonds but longer maturity bonds, allowing them to lock in low rates of funding for extended periods.

The need for yields higher than those of low yielding government bonds, combined with improving corporate fundamentals, has driven the performance of investment grade corporate bonds.

Investment grade corporate bonds provide risk aware investors exposure to corporate debt of a higher credit quality.

Investors can gain exposure to leading companies across financials, utilities, industrials, and other sectors, across emerging and developed markets.

Investment grade debt carries lower credit risk but allows investors to earn a consistent yield.

It can be used to seek stability whilst pursuing income.

Equity dividends

There are a number of reasons for investing in income-generating equity strategies.

First of all, income dividend strategies seek to deliver more consistent payouts than broad market equity indices and aim to provide more stable income generation for investors who require regular cash flows.

Secondly, equities can help to mitigate the impact of inflation through growth in the dividend itself.

Australian fixed income

When investors are seeking income, Australian bonds are amongst the most sought after for yield and rating.

Australia is one of only a handful of countries that can boast a top-level ranking from each of the major debt rating agencies.

Australian fixed income ETFs give investors the diversification benefits of bonds as well as a reliable income stream. And unlike bank deposits, they can also provide capital gains when equity markets are volatile.

Asset allocation

The asset allocation decision should begin by considering the type of income you are looking to achieve - be it low volatility, regular, high level, or growing?

Then consider how you will build an income portfolio - be it with ETFs, with actively managed funds or a combination of both.

Allocation to active strategies should be considered when you are seeking to achieve specific outcomes or when you have clear conviction in a manager beating a benchmark.

Allocation to ETFs should be considered when the objective is to attain low cost, targeted exposure, or to implement a tactical idea.

These days, the ETF market in Australia is such that the number of exposures available allows advisers to create truly diversified multi asset portfolios targeting a specific level of risk and optimising for income.

There are a number of reasons why advisers are increasingly using exchange traded instruments in their business - these include simplicity, liquidity, and cost effective diversification.

Regardless of the investment vehicle chosen, a robust approach to building income portfolios seeks diversified sources of risk and return - including non-traditional sources of income.

Principles of income portfolios

Risk, return, yield, and yield growth should be considered in order to strike the balance between the investment objective and the acceptable risk level needed to achieve it.

Achieving a specific yield target over the last five years has required increased diversification as government bond yields have fallen.

This highlights the need for more flexibility in meeting income needs and regular monitoring of a portfolio.

Diversifying assets across multiple asset classes brings diversification of risk as well as diversification of returns.

The addition of different types of risk into a portfolio can allow investors to achieve better risk adjusted returns overall.

Specific risks to be considered include the impact of a change in interest rates, inflation protection, issuer risk within credit exposure, foreign exchange, as well as equity volatility.


Jon Howie is head of iShares Australia.

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