Eugene Philalithis, Portfolio Manager of the Fidelity Multi Asset Income Fund Range, discusses the love affair between income investors and equities over the past decade. Why are investors favouring European equity income stocks over European high yield bonds?
16 Feb 2018
Eugene Philalithis, Portfolio Manager of the Fidelity Multi Asset Income Fund Range, discusses the love affair between income investors and equities over the past decade. Why are investors favouring European equity income stocks over European high yield bonds?
Income seekers have grown used to equity investing over the last 10 years. Amidst a general collapse in yields, equities are the only major asset class to have maintained their yield levels from a decade ago, and have even become the highest yielding asset class in some regions like Europe. Dividend pay-outs are set to make record highs this year, with strong economic growth boosting profits and several firms issuing special one-off dividends.
There are big differences between equity regions though. The UK and Europe have long been strong dividend payers, while the US and emerging markets have traditionally been more growth focused. Other regions, like Asia Pacific ex Japan, are becoming much more important dividend payers and have room for future growth, with pay-out ratios (the proportion of corporate profits paid as dividends) remaining low, relative to other regions.
With such variation between regions, it’s important to look across the capital structure in each region to assess the underlying dynamics between loans, high yield bonds, collateralised loan obligations and equities.
Europe is a good example of this in action. Economic fundamentals remain supportive for European risk assets. The European Central Bank’s bond purchases have forced down fixed income yields over the past two years, resulting in an unprecedented situation where European high yield bonds now yield less than European equities. When taking higher risk exposure in Europe, we therefore favour equity markets, which offer us a higher income and better return prospects overall.
It remains prudent, however, to be wary of relying on dividend paying equities too much. Equities tend to be much more volatile than other asset classes, even if they have been calm to an almost unprecedented extent this year. In 2017 we saw exceptionally strong returns from the S&P 500, unseen since 1960. Strong economic growth and negative global equity supply (the value of shares issued by companies minus the value of shares cancelled) have underpinned this low volatility environment, with investors allocating to a dwindling supply of equity even as growth has strengthened.
These conditions could make any pullback in equities more painful though. I believe it’s sensible to hold some short positions to counterbalance equity exposure. It’s important to have built in protection, even if it has been a small headwind to performance this year. There are a number of risks for equity markets next year, not least European politics, with Italy due to hold elections before the end of May, and the ongoing situation between Catalonia and Spain.
Equities are not the only option available to income investors - loans are one of our other high conviction views, and it’s important to diversify higher risk exposure with defensive fixed income too. However, given the current low yield environment, equities will likely remain an important cornerstone of any multi asset income portfolio for some time. Having carefully sized short positions can help to mitigate the risks equity investors face, particularly at a time when markets have been calm for so long, and investor sentiment is high.
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. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. The value of investments and the income from them can go down as well as up and investors may not get back the amount invested. Investments in overseas markets, changes in currency exchange rates may affect the value of an investment. 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 issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. The Fidelity Multi Asset funds use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations.