Aegon Asset Management: Remaining flexible to solve the income puzzle

There has been no shortage of challenges during this decade: Brexit, a Eurozone debt crisis, a trade war between the US and China, declining Chinese growth, the COVID pandemic, Russia’s war in Ukraine.  The most pertinent from an income investing perspective has been the Bond Bull Market of the last 40 years ended by the Great Bond Reset of 2022 and 2023; almost all else has been peripheral.  See Fig 1.

Fig 1 – 10yr US Treasury and Gilt yields since 1994.

_{Source: Bloomberg}

This was helpful for bond investors who benefited from equity like returns (from capital appreciation) for much less risk but increasingly lower rates posed a challenge for income investors.  This challenge was starkly evident in the growth, from 2014 onwards, of negative-yielding debt which peaked at over $17trn in 2021. (see fig 2 below).

From the infancy of the fund, therefore, a key piece in solving the income puzzle was alternative (non-traditional) assets whose contractual cashflows offered a high initial income usually backed by a secure contract and with scope for growth, both in income and capital. They include our ‘specialist income’ investments such as listed infrastructure and renewable energy. Their characteristics are part bond, part equity and are often referred to as ‘bond proxies’.  Investing through listed investment vehicles (the fund cannot invest directly in real assets) allowed access to the contractual cash flows of such assets as well as valuable visibility on pricing and liquidity.  Whilst not a thematic fund, many of these specialist income alternatives naturally enjoy a positive and higher correlation to inflation and investment themes tied to longer term secular shifts (such as energy transition and digitalisation of the economy) which reinforced their attractiveness.

_{Fig 2. Source: Global Aggregate Negative Yielding Debt (left hand scale) from Bloomberg as at end-Dec 2023.  Aegon DMIF’s ‘Specialist Income’ allocation history (right hand scale) as at end-Dec 2023}

As the bond bull market continued to build, and its value for income investors diminished, our ‘specialist income’ allocation grew.  From 11% of NAV at fund launch, our exposure rose to a peak of 24% in October 2021. Recognising the impact that shifting rate expectations would have we began to cut our exposure before Central Banks started to raise rates and continued through 2022.  Our exposure is again now just 11% of NAV.  

Not all alternatives come in listed equity form.  We have also favoured the more specialised bond diversifier of Additional Tier 1 (AT1) Bank debt securities which were first introduced after the 2008 financial crisis and which, over the life of the fund have delivered better total return than other credit classes (fig 3).  

The debt capital tiers of European bank debt are about as complex as it gets. AT1 debt is a key source of financing that helps banks improve their capital positions to meet regulatory requirements.  It is not without risk; considered just above equity in the capital stack and defined by its ability to be written down or converted to equity in times of stress. Given the intricacies of this asset class, understanding documentation and jurisdictions is paramount so our strong collaborative working relationship with our asset class specialist colleagues is vital in tailoring security selection to meet the return and risk requirements of the fund. 

_{Fig 3. Source Bloomberg as at end-Jan 2024}

Bank credit, including AT1 debt, provides attractive investment opportunities, combining diversification benefits as well as attractive income.  The income of course is contractual, unlike the dividends from equities many of which were stopped in Covid.  Total return is comparable with, but materially less volatile, than that from bank equity.  Complex and idiosyncratic in nature, this is an example of where active management can add value as experienced specialists can help investors access the potentially lucrative, and large, AT1 component of the fixed income universe.

With no benchmark or strategic asset allocation frameworks to restrict our ability both to pre-empt or to respond to market developments, we use our flexibility to the fullest to adjust our exposure to this asset class (and others) as appropriate.  We first invested in Bank Credits (including AT1s) in January 2016, a modest allocation of c.2.5%, which increased to roughly 10% at the end of 2018 where it stayed until March 2020. As active investors, we look to benefit from bouts of volatility that lead, in our view, to mispriced risk opportunities. For example, we increased exposure after Covid-induced market volatility, captured some attractive alpha in this area and reduced exposure once valuations had normalised. 

More recently, we increased our exposure once again following the emergency take-over of Credit Suisse by rival Swiss bank UBS in March 2023.  Swiss regulators wrote-off Credit Suisse’s $17 billion in AT1s (to which we had no exposure) and the ensuing wider market dislocation was an attractive entry point. Our allocation grew from 10% in March 2023 to 15% at the end of Dec 2023 and we remain enthusiastic about return prospects here. 

Whilst alternatives have been an important part of the fund’s composition, the Great Bond Reset has changed the nature of the income puzzle:

• elevated yield levels in core fixed income markets once again allow investors to own bonds for their income generating qualities. Our credit exposure grew from around 35% of NAV in Q4 2022 to a record high of almost 50% in mid-2023. For the fund, our credit bonds delivered consistent returns during 2023 and our high yield allocation, with low double digit returns, was the best performing credit allocation on a risk adjusted basis.   
• We can look to bonds for other qualities. Adding to bond allocations, particularly investment grade, allows for lower volatility. When uncertainty remains significant and asset correlations high, we prefer to tilt towards the contractual income of bonds and their pull-to-par nature which aids total return. 
• Improved bond valuations offer a chance to reshape the equity component of the portfolio, by geography, sector or theme.  It permits reallocation of capital from income-generating equities into growth-focused companies; it would have been difficult to own 2023’s stars such as Microsoft and Broadcom when income was scarce since they yield less than 1% and 2% respectively.
• Markets wax and wane with the economic cycle as we have seen in the ten years since the fund’s inception. Navigating that in real time through an active, flexible, bespoke portfolio is key to solving the income puzzle.

_{*Source: Aegon Asset Management UK, as at 1 February 2024. Aegon Diversified Monthly Income Fund B Inc share class average of historic yield since inception. The Fund launched on 25 February 2014.}

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