Income investing: Reset your expectations

Higher yielding bond sectors in particular have been beneficiaries of the ongoing grab for yield, especially against a backdrop of trade hostilities, lacklustre global growth and muted inflation. Flow data clearly shows that investors prefer bonds.

About USD487 billion has flowed into fixed income funds in the first half of 2019, up from USD148 billion in the first half of 2018, according to Morningstar. It is the highest level of first half net inflows into bond mutual funds for at least a decade. These flows show no signs of abating. In July, global bond funds enjoyed net inflows of USD17 billion, the seventh consecutive month of positive net flows. Within Asia, bond funds saw USD59 billion of net inflows in the first half of the year, versus USD9 billion of outflows for equities.

The large inflows have in turn driven bond yields down close to record lows. The US 10-year Treasury bond yield is currently at 1.85%². Over in Asia, all-in yields are close to the lowest level historically. See Fig. 1. These large inflows and low bond yields have implications for investors.

Fig. 1. All-in yields (Asia, %)³

For one, given lower yields, any volatility in bond prices will have a bigger impact to total bond returns. This potentially changes the profile of the asset class which has historically appealed to investors for its defensiveness and lower volatility.

Bond volatility already appears to be on the rise. The MOVE Index which measures bond market volatility, hit a three-year high in August following weaker-than-expected US job numbers and a sharp decline in US manufacturing activity. See Fig. 2. With positioning skewed towards bonds, typical swings in bond prices could be exacerbated if investors reduce their portfolio holdings.

Fig. 2. Bond market volatility appears to be on the rise⁴

Meanwhile, the grab for yield has driven some investors into sectors which they have traditionally not invested in before. This change in investor profile can aggravate volatility spikes – for example in August, Chinese high yield property bond issues sold off sharply as global emerging market bond funds sought to raise cash.

It also does not help that the profiles of selected bond indices have changed. For example, nearly 50% of the US Investment Grade index now comprises of corporates that are rated BBB, one notch above junk, versus 35% in 2008⁵. The risk of downgrades will rise if the economic slowdown accelerates. Changes in index composition can in turn trigger greater volatility, particularly given the popularity of exchange traded funds.

Alongside bonds, income seeking investors have also looked to other asset classes including dividend paying equities and real estate investment trusts (REITs). While dividend paying equities have traditionally been viewed as being more defensive, deteriorating earnings may impair the dividend outlook in the short term.

Meanwhile, excess supply in selected segments, weak retail sales and potential regulatory changes are possible challenges confronting REITs. Emerging trends such as co-living, co-working, tokenisation of real estate as well as implications of climate change can also disrupt business models.

This is not to say that income seeking investors should avoid bonds. Interest rates and yields are likely to remain low for some time, in my view. According to the World Bank, global growth prospects remain dim with the outlook deteriorating amid Brexit-related uncertainty, trade tensions and a downturn in Europe. Central banks are likely to cut rates or keep them low as an insurance against further economic damage. This will be supportive of bonds. Bouts of volatility can present attractive opportunities for active long-term investors who are able to perform careful risk management and analysis. There are also opportunities to enhance returns through carry strategies.

Yield curves in selected countries are still upward sloping, offering investors additional yield as they extend their maturities.

Meanwhile, the ability to identify stocks that can deliver sustainable dividend growth can help portfolios navigate bouts of short-term volatility. While market sentiment may be driven by trade tensions and/or Fed policy in the short term, markets have historically tracked dividend growth over the long term. See Fig. 3.

Fig. 3. Annual stock market performance and dividend per share growth since 2010⁶

As for real estate, high net worth (HNW) investors have been increasing their allocation to the asset class, especially in Asia, given falling bond yields and the volatility in the equity markets. In 2018, real estate accounted for 20.1% of Asian HNW investors’ total asset allocation, up from 18.7% in the prior year. This demand can help underpin the valuations of real estate assets and real estate linked securities even though valuations of REITs have climbed. In addition, an active bottom up approach that seeks to identify companies with quality management, assets in good locations and strong balance sheets would be better able to navigate some of the challenges faced by REITs mentioned earlier.

Income paying solutions are likely to remain popular in a world of low yields and muted growth. That said, unless investors are prepared to take on more risks, they would need to reset their expectations and expect more moderate returns. Volatility may also be more elevated. A longer-term mindset coupled with an active approach, can help mitigate some of the challenges whilst taking advantage of the potential opportunities which volatility brings.