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Expensive 'defensives', stingy bonds: where is safe for income?

With reliable dividend payers having reached heady valuations and bonds offering ultra-thin yields, is anywhere safe for income investors?

by Rob Griffin on Jan 07, 2016 at 16:30

It is a difficult time to be an income investor. Negative outlooks for many fixed income sectors and stock market volatility have contributed to an environment of uncertainty.

Nick Samouilhan, a fund manager in the multi-asset team at Aviva Investors, believes 2016 is all about lowering expectations after a five-year period during which investors enjoyed strong performance.

‘We’re big investors in both high-yield and emerging market debt, while within equities we continue to skew the portfolio towards markets where policy is supportive,’ he said. ‘This means being overweight Europe and Japan, and underweight the US and the UK.’

Click through the slides for fund managers' views on the outlook for income investing this year.

Next: rate rise 'pressure point' for dividend payers

Rate rise 'pressure point' for dividend payers

James de Bunsen, a fund manager in the multi-asset team at Henderson Global Investors, is worried about 'bond proxies', dividend-paying shares which are meant to show resilience in the face of market volatility.

Investors have increasingly flocked to these shares as quantitative easing has driven down the yields on bonds, forcing them to look elsewhere for income.

‘We’re still in a world of quantitative easing in Japan and Europe, which ultimately forces people along the risk curve,’ he said. ‘So when they’re not getting enough income from their bonds, they look at bond proxies.

'Our concern is that it’s been popular for a long time and, as with all crowded trades, when it turns the losses can be accentuated by everyone heading for the exit.’

Samouilhan also has reservations. ‘High-yielding stocks were one of the biggest beneficiaries of really low policy rates and everyone looking for income,’ he said.

‘As the US Federal Reserve normalises rates [following December's rate rise], these high-yielding stocks have to be a pressure point because those are the names everyone went into when yields were very low.’

Next: stingy government bonds

Stingy government bonds

When the starting point is not a particularly high yield, the prospects can be challenging for investors, said de Bunsen.

‘We’re not forecasting a rout in government bonds just because central banks are about to start raising rates,’ he said. ‘Our base case isn’t a sharp sell-off; it’s just we see a low yield that isn’t very attractive.’

He also questioned whether the reasons to invest in government bonds were still relevant. ‘Since the turn of the century they’ve done investors proud whenever equities have sold off, but I'm not sure you can rely on that going forward, particularly in a rising interest rate environment.’

However, Citywire A-rated Bryn Jones, head of fixed income research at Rathbones, said that index-linked bonds, whose payments rise in line with inflation, looked attractive.

‘The risks to the inflation rate are skewed to the upside and continue to suggest that breakevens [the level of inflation above which an index-linked bond will pay out more than a conventional one] are too low for the macroeconomic outlook,’ he said. ‘Core inflation has been held back over the last two years by low wage inflation.’

Low wage inflation can be broadly attributed to four factors: underemployment, a negative shock to inflation via commodity prices, stalling productivity growth and downward rigidities due to the hoarding of higher value personnel by firms during the recession.

‘All four of these factors have continued to dissipate this year and are likely to continue to do so in 2016,’ said Jones.

Next: not all bonds are expensive!

Not all bonds are expensive!

Bob Jolly, head of global macro, fixed income, at Schroders, believes corporate bond markets may offer a degree of shelter.

‘Pockets of value have emerged in the energy sector, as well as more generally in financials,’ he said. ‘Euro investment grade corporate markets have also grown cheaper during the year.’

Jim Leaviss, head of fixed interest at M&G Investments, said there were two significant supports in place for credit markets coming into 2016.

‘Credit spreads [the extra yield compared to government bonds] in both investment grade and high yield are likely to overcompensate for expected default rates; and, in a world of low or negative yields in government bonds, investor demand for credit remains firm,’ he said.

Next: if you don't like bonds and shares...

If you don't like bonds and shares...

Samouilhan said that of the income alternatives to bonds and shares, he liked property, but was planning to reduce his exposure over the next 18 months.

‘In a low-return world, you want something that has a decent yield and the possibility of some capital growth, and property fits that quite well,’ he said.

‘However, it’s also one of those asset classes that is bricks and mortar, meaning there’s a cost of trading; and in this kind of environment, you want to minimise costs.’

De Bunsen suggested loans were worth considering as they were less volatile and risky than high yield, but just out of favour with the markets.

‘It’s one of our favourite areas, as loans are senior secured debt instruments that are at the top of the capital structure and secured against assets,’ he said. ‘If a loan does default, you have high recovery levels and these have been about 80% over the last 20 years.’

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  • Nick Samouilhan
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  • Bryn Jones
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  • Bob Jolly
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