No Free Lunches As Investors Seek Income
With interest rates so low, the hunt for an income becomes more urgent but there are no free lunches in investment, and obtaining higher yields means more risk, say wealth managers.
Dramatic interest rate cuts have pushed savings rates off a cliff, while demand for the relative safety of government bonds has pushed yields down. As traditional sources of investment income have dried up, investors are looking elsewhere but as recent history suggests, the hunt for income in a low-rate environment means taking more risks.
Arguably, the current financial crisis has been caused by lending to sub-prime and other relatively risky borrowers because in a low-interest rate environment, banks and other investors could only earn a relatively high yield by moving up the risk scale.
“In chasing one solution, there may be risks which clients are neither aware of nor comfortable with,” Torben Nielsen, head of balance sheet at Barclays Wealth, told WealthBriefing recently.
Thomas Becket, head of global strategy at PSigma Investment Management, agrees that higher-yielding assets pay higher yields for a reason: “Generating a yield of 5 per cent in this environment is incredibly difficult, unless you take an unsuitable amount of risk,” he said.
And Graham Wainer, who is head of private clients for GAM, is also of the same view: “To look for income at any cost is a mistake. “Investment in government bonds and corporate bonds should be very selective and appropriately sized."
Cash now forms substantial proportions of clients portfolios – up to 20 or 30 per cent in some instances. One vital issue for investors to understand is liquidity.
“Liquidity is a measure of how quickly you can access an investment decision. More liquid bonds offer lower yield and a higher return is often available with less liquidity,” said Barclays Wealth’s Mr Nielsen.
In the last 6-12 months, Mr Nielsen has noted an increasing appetite for government bonds and Treasury Bills as a safe haven in the turmoil despite their low yield as they offer high liquidity and security.
“Supranational bonds offer a higher yield, but with slightly less liquidity so are useful for a buy and hold strategy. We also have some appetite in the corporate sector particularly for banks senior debt,” he said. “It is important to consider the risk parameters and the longer the investment duration the better the return.”
For its clients seeking income, PSigma is currently recommending fifty per cent in high yielding blue chip equities, a maximum of ten per cent in diverse range of high quality corporate bonds and most of the rest of the portfolio in government fixed interest. “Given the attractive yields on offer from investment grade corporate bonds, we do not feel it necessary to venture too far down the quality scale”, said PSigma’s Mr Becket. “Although the yields on offer from quality sovereign bonds and cash are unattractive, we are still living in a safety-first investment environment.”
To balance potential return for dissatisfied cash clients with a suitable time frame, Collins Stewart Wealth Management splits its bespoke cash deposit alternative portfolios into equal one-thirds apportioned between index linked debt, government backed issues and corporate bonds. Inflation linked bonds provide investors with a low fixed coupon with an inflation adjustment added to both the interest payments and a final payment. This, combined with the government backed portion and the higher return for a higher amount of risk invested across a wide diversity of names in corporate bonds, provides a yield of 4.25 per cent for the portfolio to maturity.
“It is carefully balanced so that clients don’t suffer dramatic market volatility in order to achieve their income objectives,” explained Chris Huelin, head of fixed interest at Collins Stewart. “In January, the gilt index fell 4.5 per cent. However, the 'Yin and Yang' design of our cash alternative portfolios means that the index linked element supports the fixed income element and thus there was little capital movement in these portfolios.”
Collins Stewart’s house view is that market expectations around deflation have been overdone and index linked securities have therefore been undervalued. “There has been a rally on the back of the government’s quantitative-easing programme, but short and medium dated inflation linked bonds still offer value,” said Mr Huelin. Concerns around inflation in the long-term means the firm is avoiding being too overweight from a duration, or maturity, perspective.
For those clients that want exposure to world growth, the firm has introduced an equity element ‘defacto’ through a hedge fund exposure. In this instance 66 per cent of the portfolio is invested as per the cash alternative portfolio and the remaining one-third in Collins Stewart’s Fund of Hedge Funds.
Money market funds are an ‘off-the-shelf’ solution, popular with clients targeting income. At the moment, these pooled investment vehicles, made up of highly-rated money market instruments, offer yields that are significantly positive to base rate. Sterling denominated funds, for example, currently offer up to 1.77 per cent, depending on provider, compared to bank base rate at 0.5 per cent.
Cash money market funds offer diversity and better liquidity, whilst also spreading risk, according to Barclays Wealth’s Mr Nielsen. “However, it is important to choose an experienced fund manager.”
Iain MacKenzie, head of treasury at Collins Stewart Wealth Management, believes that money market funds can be used alongside more bespoke income vehicles to provide clients with cash options across both a longer and shorter term time horizon.
“Some money market funds are offering equivalent rates to 3-6 month Interbank rates but with the funds at investors’ disposal,” he said. “There are diversification benefits and less concentration of risk as they are invested across a whole host of underlying assets. Another advantage is that they can invest along the yield curve therefore offering a longer weighted average maturity.”
During the savage and unexpected moves in interest rates at the end of 2008, money market funds provided insulation as their rates move more gently, only when underlying investments mature and are replaced, providing a useful time lag.
Money market fund worries
Concerns about money market funds voiced last year when the US
Reserve Primary Fund “broke the buck” and failed to return
investors’ money in full due to its exposure to Lehman Brothers
debt, knocked confidence in these funds. However, the IMMFA, an
industry body representing providers of AAA rated MMFs, has
sought to dispel similar concerns in the
UK. Whereas big providers such as BGI, Scottish Widows and ock might have seen a dip at the end of last year due to these concerns, they have now seen a recovery of monies under management.
“Money market funds are normally useful in a rate-cutting phase but not so good in a rising interest rate environment. However there is no way governing bodies will raise rates in the near future,” Mr MacKenzie said. By pooling clients’ funds, Collins Stewart Wealth Management can obtain higher call returns than by clients placing money themselves.
According to Barclays Wealth’s Mr Nielsen, while returns have fallen, it is also worth looking at bank deposits, particularly since following the effective underpinning of the banking sector, risk has gone down. “Banks are rebalancing the funding risk and there are good deals available from the market from time to time and we take these off the shelf,” he said.
Ultimately, while there are strategies that can enhance yield in the prevailing zero interest rate environment, there is no getting away from the fact that income levels are quite low across many asset classes.
“It’s a feature of the crisis and investors should get comfortable with it rather than instinctively trying to generate income, which could lead them into potentially overbought situations,” concludes GAM’s Mr Wainer.
The key for wealth managers is to tailor a solution for individual clients without taking inappropriate risks. There are, as ever, no free lunches in investment.