Given this significant decline in yields and the low level of interest rates, it is unsurprising that investors are being forced to move further up the risk scale in an attempt to replace lost income. Evidence for this can be seen in chart 2, which details the capital inflows and outflows of the key income producing sectors over the last 12 months. This shows that capital has been removed from gilts and investment grade corporate bonds and invested instead into strategic bond funds. These latter products typically hold a significant portion of their assets in high-yield debt and therefore carry greater credit risk than investment grade funds.
As investors and their advisers have sought to increase the yield on their capital by accepting greater credit risk, fund managers have also been re-orienting their portfolios towards higher-yielding assets in an attempt to offer a competitive yield. Importantly, this sharp increase in credit risk is not necessarily obvious to investors as the funds’ aggregate exposure to investment grade debt may remain unchanged.
These less visible moves in risk at the fund level should be of particular concern to advisers as they indicate a possible distinction between the asset allocation structure created by the adviser and the actual exposure of the underlying funds. Such disparities tend to remain hidden while defaults and volatility remain low, but become obvious during periods of higher volatility and increased incidence of defaults.
This focus on superficially attractive initial yields reflects the fact that many traditional income portfolios are built with a specific target yield (say, 4 per cent), or are optimised to maximise the initial yield within the context of a target risk profile. However, both of these approaches tend to overemphasise the returns of the recent past at the expense of the long-term sustainability of the income. Few of us would accept a job that generated a high salary last year but that provides no indication of the next year’s likely income, yet this is in effect what happens when someone invests on the basis of the initial yield of the portfolio.
This prompts the question, how should income portfolios be structured?
While there is no single right answer, the key to success is to select the right tools for the job. For an income portfolio to represent an effective long-term replacement for earned income, it must focus on the sustainability of the income stream, not just the starting yield. Traditional capital market assumptions – the building blocks of a strategic asset allocation – do not take into account income stability and so must be replaced with new assumptions that do. Second, the asset allocation process must consider the income volatility of each asset class in addition to the expected yield, risk and total return.
