Investors need to invest more broadly across asset classes to build a resilient income-yielding portfolio.
Historically, investors looking to create a balanced and resilient income-yielding portfolio aimed for a 60:40 percentage split between equities and government bonds.
Bonds tended to rise in value as interest rates were cut to support the economy when stocks were falling, so the fixed income element provided not only a reliable income but portfolio protection against the full impact of stock market falls during volatility.
But all that has changed, as a recent research paper from JP Morgan makes clear.
Even before the Covid-19 pandemic, a decade and more of quantitative easing had pushed interest rates to historic lows. Now, with “a mountain of debt” accrued in the fight to keep our economies afloat during lockdown, there’s nowhere to go. JP Morgan expects rates to remain “at or below zero for an extended period of time”.
Because ultra-low rates combined with massive monetary and fiscal stimulus cripple government bond yields, these bonds are no longer a good way to shore up portfolios in recessionary times.
They may provide some diversification in market crashes, but they yield next to nothing in the meantime. JP Morgan calculates that a traditional 60:40 portfolio will have an annual compound return of around 4.6% a year on average over the next decade.
Tom Becket, chief investment officer at wealth manager Punter Southall, agrees that the prognosis for improvements in total returns from a traditional split portfolio is not healthy.
“A traditional 60/40 approach to portfolio management is not the optimal investment approach for the future and will not be anywhere near as successful as it was in the past. In fact, it could very disappointing,” he says.
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That, of course, raises the question of where investors on the hunt for the valued combination of income and diversification can turn to stop the gap. Simply dialling up the proportion of equities relative to bonds would maintain returns but is a recipe for increased risk, which may not suit investors with shorter timescales.
So one step is to branch out into other fixed-income classes beyond government bonds. The problem is that although they offer much more attractive yields, they also tend to be more closely correlated with equities.
Funds favouring high-yield bonds are one option as far as boosting income is concerned. But as JP Morgan observes, they are not a panacea for volatility: “In the past, some high dividend-paying sectors have also been some of the most volatile parts of the markets.”
Becket, meanwhile, favours bond funds that invest in shorter duration assets that are less sensitive to rising bond yields. “There are also relative value opportunities within specific corporate bond sectors such as bank credit, and in non-traditional parts of the bond market such as asset-backed securities,” he adds.
Equally important in the quest for the holy grail of resilience and income is the inclusion of alternative assets – although again, they can show close correlation to equities if they are held in a listed form (listed property securities, for instance), and can also be relatively illiquid.
Becket highlights the strengths of commodities in terms of both diversification and protection against the rising risk of inflation.
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JP Morgan, meanwhile, sees the merits of real estate’s superior yields to government bonds. Although the pandemic brought new difficulties for parts of the property sector including office space and retail, it also opened up new opportunities in areas such as warehousing. “Selectivity is critical,’ the report stresses.
Global infrastructure has historically been a robust choice: with yields around 7% it is an attractive alternative to government bonds, and has generated “remarkably consistent and defensive income streams in different periods, including the last two recessions, thanks to often contracted or regulated cash flows”.
Hedge funds are a useful counterbalance to the inherent illiquidity of property and infrastructure. The asset manager identifies macro strategy hedge funds in particular as historically doing the best job of protecting portfolios. Such funds base their holdings primarily on the overall economic and political views of various countries.
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Clearly, the way forward in these days of zero interest rates is through a much more broadly diversified range of asset classes, each of which brings its own strengths - and weaknesses – to the party.
And that in turn is likely to involve professional input. “Our diagnosis is that more than ever, the enhancements available through skilled active portfolio management and by thinking differently are the key to generating sufficient returns in the future,” Becket says.
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