01 Jul 2020
Covid-19 has already had a significant economic and social impact with extensive monetary and fiscal policies implemented to help mitigate the cost of the pandemic. This new world raises new challenges for income-seeking investors - we assess how and where investors might reach for yield.
While some of the pre-pandemic challenges persist (such as ageing populations and low interest rates), these have become background music to a new theme of financial repression. Notably, this is likely to crowd investors into an even riskier mix of assets with very few low risk income-generating assets now producing meaningful cashflows. At the same time, uncertainty also benefits investors who can draw on extensive research capabilities to understand the implications of wider market dynamics on companies at an individual level.
The downturn resulting from Covid-19 will be particularly severe, according to the International Monetary Fund who said this pandemic will bring “a deep recession” which will “involve solvency issues” and “leave scars”.
This situation raises specific challenges for income investors, who pre-Covid-19 had been tempted to invest up the risk curve in the hunt for yield. However, at Fidelity, we would caution against over-reaching for yield in the current environment and across our portfolios both quality and liquidity remain key areas of focus.
The disruption from the pandemic is already showing a wide disparity in company performance. This is only likely to accelerate. For income investors we believe there needs to be a tilt to quality across all asset classes. In order to have certainty of cashflow generation, we must identify companies with balance sheet strength, good governance, transparent business strategies and strong, experienced management teams.
We believe our deep research capabilities and experienced investment teams allow us to identify strong companies and navigate the risks. As actively engaged shareholders, our investment teams cultivate strong relationships with company management and are able to take high conviction views, supported by a large global research operation which allows us to understand the key drivers of corporate profitability.
With government bonds offering little in the way of reward, investors will need to re-evaluate their priorities in the coming months. Those with no appetite for risk must accept that the current environment offers only negligible rewards for sticking solely to reliable income sources.
There are still good reasons to hold government bonds as part of a well-diversified portfolio, but for investors looking to source income in a more selective, risk-conscious manner, high quality corporate bonds are a good place to start. In a low yield environment, the yield pick-up you get from investment grade corporate bonds (over government bonds) is attractive in our view.
With interest rates anchored at low levels for the foreseeable future, there is likely to be a positive spill over effect in terms of demand for corporate bonds in the medium to long-term. It is also worth noting that global central banks will be buying high quality corporate bonds in unison as part of quantitative easing measures.
For income-seeking investors with a higher risk tolerance, high yield corporate bonds still play host to attractive mid-to-high single digit yields too. However, reaching for yield is not without risk, and recent market movements have served as a timely reminder of the importance of credit quality.
In this regard, it is important to recognise that there will be a likely increase in corporate debt defaults as the economic pain of the global lockdown is felt. This will present big challenges for corporate bond investors as we move through to recession. Monetary and fiscal support are no substitute for intense scrutiny of corporate balance sheets, and a large research function will be paramount to navigating this challenging period ahead.
Finally, while we think the low growth, low inflation environment will persist, investor should also take care not to overlook inflation-linked bonds entirely. These instruments behave quite differently to other fixed income assets and can be a useful hedge for investors concerned about a rise in inflation expectations. Given the amount of debt that has been pumped into the global financial system recently, it could be prudent to maintain some inflation protection in the medium-term.
When pursuing a required level of income, it is important to have flexibility as it enables investors to seek opportunities from multiple sources amid challenging conditions.
For example, from an equities perspective, while we acknowledge that some companies will struggle to pay dividends this year, we realise the recession is likely to drive greater dispersion among dividend payers.
As the global economy undergoes an uneven recovery, recognising regional and sectoral disparities will be key. In this environment, using an active approach allows the flexibility navigate market challenges, identify opportunities – and act on them.
These benefits also highlight the potential pitfalls in adopting a passive approach to income investing. By taking an often index-following or rules-based system, investors may inadvertently depend on income-generating sectors like oil producers that have not generated income during this pandemic and its fall out.
We believe that income portfolios will need to retain an all-round healthy diversification profile if they are to perform well in the months and years ahead, as correlation levels between asset classes can fluctuate.
At this juncture, it will be key that investors maintain a portfolio that is fully diversified in order to navigate the challenges of illiquidity, market volatility and dividend cuts while also tackling the consequences of loose monetary policy and a flood of government debt. Ultimately, investors will need to consider why they have an income portfolio and what it is designed to achieve. The kind of income they are seeking should steer decision-making on risk tolerances and the liquidity profile of their overall investment mix.
In the current market, investors may need to adapt. It will require some careful planning, as to which different income streams can be combined to deliver something which best suits their needs.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.