By Karen Watkin, Portfolio Manager – Multi-Asset Solutions at AllianceBernstein and Morgan Harting, Portfolio Manager – Multi-Asset Solutions at AllianceBernstein
Market shocks tend to create significant opportunity for income-seeking investors. Since the coronavirus downturn, the opportunity to capture yield in dividend-paying stocks, real estate investment trusts, high-yield bonds and other income-generating assets has improved dramatically. A diversified multi-asset portfolio that searches globally and beyond traditional asset classes for income and growth can provide investors with access to the widest range of return sources to meet their needs.
The time is right to search for income-generating assets. As the coronavirus pandemic upends lives and economies globally, securing sources of future income has become a pressing need. Suddenly, the health of billions of individuals is at risk. Jobs can no longer be taken for granted. And even after an initial recovery from the meltdown in March, market volatility persists.
At a time when a steady income stream—whether from a pay cheque or a dividend-paying blue-chip stock—is no longer assured, finding ample helpings of yield in an investment becomes even more critical. Indeed, during periods of extreme uncertainty and economic dislocation like the COVID-19 crisis, income can be a source of peace of mind.
In fact, market shocks tend to create significant opportunity for income seeking investors. The downturn left valuations much more attractive than they were at the beginning of the year across income-generating assets such as dividend-paying stocks, real estate investment trusts (REITs) and high-yield bonds (Display). Yields are similar to or better than they were at the beginning of 2020. And during recoveries from downturns in the past, income assets have performed well.
What are your income goals?
The market crisis shouldn’t be a distraction from income-related goals. For many, income investing is used to deliver cash flow for retirement—a challenge that’s becoming more daunting as people live longer. But income isn’t only about retirement. Income flows can help support many financial goals such as the purchase of a home, payment of school tuition and even more mundane monthly costs like utility bills or car repairs.
With the right approach, high and sustainable income is achievable through changing market conditions. This can be done by tapping into sustainable distribution yield from income sources such as interest payments and dividends. What’s more, combining asset classes that provide high current income with those that provide growth potential can help investors grow their capital over the long term. Income strategies are also a good way for investors to protect themselves from the inflation which can erode the value of their assets.
Capturing these benefits requires a flexible and unconstrained investing approach. This refers to an investing approach in which a portfolio can include a wide range of assets, from stocks to bonds to alternatives, without being tied to a benchmark. When executed in a strategic and actively managed portfolio that searches globally and beyond traditional asset classes for income and growth, investors can enjoy access to the widest range of return sources to meet their needs.
How COVID-19 remade the income landscape
In just a few weeks during February and March, the spread of the COVID-19 pandemic dramatically reshaped the market landscape for income investors. At the start of 2020, yields surpassing 5% were scarce, which meant that income-generating assets were very expensive. So when the market sold off, there was no cushion for investors and income assets sold off indiscriminately. However, the scale of the market sell-off in March has created the best opportunity to capture yield in a decade, in our view.
Before the crisis, income investors faced a complicated challenge. Low to negative central bank rates and extremely narrow spreads left exceedingly rare opportunities to capture yield without accepting generous helpings of risk.
Then, as the pandemic silenced business activity throughout the world and unemployment spiked to historic highs, the global economy faced recession. Equities and bonds nosedived until the dramatic fiscal and monetary intervention by governments and central banks worldwide calmed investors and spurred a rally. Assets were revalued dramatically. The economic contraction and the liquidity crunch prompted a repricing of yield curves and interest-rate spreads on fixed-income securities.
In the new market environment, the breadth of equity and fixed-income assets yielding above 5% has increased significantly. Across fixed income, interest-rate spreads—the difference between yields of a riskier asset and a safer asset, such as a government bond—have expanded to their widest since the global financial crisis (GFC) (Display, left). A wider spread implies that the asset will pay a much higher yield to an investor who takes on the risk of the asset. And in the past, when spreads widened dramatically, strong returns typically followed as markets normalized. For example, when spreads between US high-yield bonds and US Treasuries widened to 1,000 basis points in the past—as they did on 25 March—investors benefited from returns of 25% over the next six months and 46% over the next 12 months (Display, right).
A brief income asset taxonomy
Even in unsteady markets wracked by economic uncertainty, it’s possible for investors to chart a course toward steady sources of yield and capital appreciation. To achieve that goal, investors can make use of a wide variety of asset classes and subcategories. Following is a brief overview of the main components of a multi-asset income portfolio.
- Bonds have been the traditional means to capture reliable income streams. Fixed-income assets like investment-grade sovereign debt are important because they usually help add a measure of stability when equity markets are in turmoil. High-yield corporate debt, on the other hand, offers the opportunity for more income, usually with return patterns that are uncorrelated with interest-rate sensitive assets like government bonds. That means they don’t move in the same direction at the same time and can offset each other during rough performance patches. Investors need to be aware of the risk/return proposition within fixed-income assets: while investment-grade bonds deliver income and stability, they often sacrifice growth. High-yield issuers expose investors to more risk—particularly today when many companies face greater bankruptcy risks because of the recession.
- Equities that pay dividends offer another avenue for tapping into income. Dividend stocks can also provide a relatively greater degree of capital growth than bonds. Yet, higher-yielding equities can expose investors to drawdown risks that make them more vulnerable as concentrated or stand-alone investments.
- Hybrid assets exhibit attributes of both bonds and equities, adding further diversification. For example, preferred shares issued by real estate investment trusts (REITs), are obliged to pay dividends at higher rates and before any payments to common shareholders. REITs are equities that have some bond-like features: they pay dividends on a set schedule, have a par value and are sensitive to interest-rate fluctuations. We believe preferred REITs are an attractive way to capture higher yield relative to fixed income and typically have lower volatility than that of more conventional equities. However, real estate sector risk can increase the volatility of REITs during cyclical downturns. Indeed, during the coronavirus market crash in early 2020, REITs performed poorly.
- Non-traditional income assets can also enhance a portfolio’s diversification offering additional sources of income beyond those available in traditional assets. These include options strategies, currency and interest-rate alpha strategies, and master limited partnerships (MLPs).
Capturing yield and growth with flexibility
The multi-asset approach seeks to answer the dilemma of investors who aspire to generate steady, robust annual payouts while preserving capital: how to maintain a balance between yield and capital growth while managing the risks of income-oriented assets.
Emphasizing any one priority can throw off the balance of the other components of the equation. Leaning into high-yield assets might enhance return potential, but could also add risks to a portfolio. On the other hand, investors that play it too safe will have to settle for more modest returns and lower yield. We believe that investors can find the sweet spot by sourcing higher-yielding securities across a diverse, global set of asset classes. With a flexible and unconstrained approach, investors can tap multiple sources of yield and returns, with different return patterns (correlations less than 1) from equities (Display).
Employing a diverse multi-asset portfolio expands investors’ opportunity to capture yield. Surprisingly, building a portfolio from a broad array of higher-income assets doesn’t pile up undue amounts of risk. Even when accounting for the poor performance of MLPs and REITs during the coronavirus downturn in early 2020, our analysis shows that a diversified multi-asset income strategy delivered higher yields over the long term than their lower-income peers without proportionally higher risk.
The benefits of diversification can be powerful. Just as adding a wider range of bonds has the potential boost yield and returns for balanced fixed-income portfolios, expanding to a multi-asset income allocation also improves the outcome.
If an economic recovery gains traction, it could well be the time for income assets to shine. Income assets have typically outperformed traditional assets by significant margins during market recoveries.
For example, by expanding the reach of a balanced portfolio combining just investment grade bonds and global equities to include high-yield bonds, high-dividend-yield equities and REITs, an investor could have generated an annualized return of 7.1% from 2002 through 2020 (compared with the 5.9% return of the balanced portfolio). In a diversified multi-asset income portfolio that extends duration by adding longer-term global treasury bonds, the return improved to 8.0% with similar volatility to the balanced income portfolio.
Multi-asset income allocations do have somewhat higher volatility than most fixed-income portfolios. However, we believe that for many investors the added benefit of capital appreciation and the higher return potential of multi-asset income are attractive trade-offs for higher risk.
For all the benefits of diversification, investors must be on guard against unintentionally concentrating in certain categories of risk. Each asset class has its own set of risks. So multi-asset investors need to ensure they aren’t piling up on overlapping pitfalls such as interest-rate shifts, low quality companies or the particularities of certain industrial sectors.
Dynamic management is essential
But even with a strategically diversified multi-asset allocation, income investors can’t be passive. To truly be effective, dynamic management is necessary.
That’s because the relative yield among different asset classes in an income portfolio is constantly shifting over time. A nimble approach is also necessary to manage risk-return trade-offs through stretches of market instability. While a diversified portfolio should have built-in shock absorbers for volatility, it may still be vulnerable to a sustained, broad-based sell-off across asset classes, such as during the global financial crisis in 2008 or the recent COVID-19 crisis.
Navigating the pandemic fallout
The onset of the COVID-19 crisis will be remembered as one of the most challenging periods for financial markets on record. In March, equity markets experienced their fastest drop in 55 years (Display, left). Global high-yield bonds and global REITs also fell sharply. Volatility reached levels not seen since the GFC. And severe losses among income assets were the broadest in history, leaving investors nowhere to hide (Display, right).
This resulted in unprecedented stress, even for a diversified multi-asset approach to income investing. Because the sell-off was indiscriminate, income assets that investors usually look to for diversification—such as REITs and high-dividend-yielding equities—underperformed the broader equity market. Similarly, high-yield bonds trailed investment-grade bonds by a wide margin. So during the period of extreme volatility, investors didn’t enjoy the defensive characteristics that diversified income assets have typically provided in the past.
In response to the market drop-off, governments around the world responded with unprecedented and coordinated action to provide liquidity to financial markets, as well as support for households and businesses.
The US Federal Reserve’s emergency programmes targeted a specific class of income assets, prompting a dramatic reversal in investment-grade bonds and US high-yield corporate bonds in April and May. However, other fixed-income securities not eligible for the programme have been slower to recover. As a result, the income environment has dramatically shifted since the start of the year—with higher yields, wider spreads and more attractive valuations across a spectrum of assets.
Capturing income recovery potential after a crisis
As the world emerges from the initial shock of the coronavirus pandemic, an attractive opportunity has emerged for income investors. Compelling and diversified sources of yield are more plentiful than at the beginning of the year. Income assets have started to rebound from March troughs in line with recoveries from previous downturns, such as the global market correction in the fourth quarter of 2018.
Though the future trajectory of the health crisis is uncertain, we believe that a broad approach to income assets should remain an attractive strategy regardless of the direction that the market takes. Today’s higher yields should provide a cushion in the event of renewed equity market sell-offs, in our view.
If an economic recovery gains traction, it could well be the time for income assets to shine. Income assets have typically outperformed traditional assets by significant margins during market recoveries. In any scenario, we believe a dynamic approach is essential. That’s because the performance of different asset classes tends to shift during different stages of the recovery. For example, after the GFC, credit led the way during the initial recovery, until the rebound broadened out in the second stage and equities surged ahead in the third phase (Display).
Pandemic volatility has created an unusually challenging market environment. Even as leading stock benchmarks have started to recover from the initial jolt of the coronavirus, macroeconomic indicators signal that the pandemic’s wide-reaching economic pain will be felt at least into 2021. Companies are grappling with increased default risk. Governments are trying to decide whether additional fiscal or monetary intervention is necessary.
But even with that nagging uncertainty, the opportunity to capture yield has grown. Indeed, during periods of economic recovery, income-bearing assets have typically significantly outperformed traditional assets. Despite expectations for elevated volatility and risk, we believe there’s a window of upside for investors willing to embrace a dynamic and diversified strategy to reach for income.