Investors have headed in their droves into cash, money market and government bonds in 2023 amid macro uncertainty. Schroders' head of UK Intermediary, Doug Abbott, considers some less well-heralded investment strategies, away from traditional equities and fixed income strategies, that are also worth considering at challenging times.
Doug Abbott at Schroders, a London-based investment manager, believes that few would have predicted that equities would roar through the first half of 2023, with US stocks returning over 20 per cent to the end of July and Europe not far behind.
“Macroeconomic uncertainty surrounding inflation, interest rates and corporate earnings, has caused nervous investors to shun riskier assets and flock towards perceived safety. The result has been huge flows into cash and low duration fixed income over the period,” Abbott said. Indeed, money market funds and Treasuries are both on track for record years of inflows, according to the Bank of America.
“Many investors find themselves caught between the attractive yields available in government bonds and cash, falling but high inflation rates, and the need to generate real return for their clients,” he continued.
In this environment, Abbott thinks there are a number of strategies and asset classes worth considering or revisiting. Here he highlights four such opportunities.
Insurance-linked securities (ILS)
“As a floating rate instrument, an ILS has little interest rate duration to speak of, leaving it relatively unscathed by the latest bond market rout,” Abbott said. If inflationary pressures persist – as most major central banks believe they will – higher rates may be there for a while. More interest rate rises will feed through to ILS investors as part of their coupon.
He believes that the current market represents one of the most attractive markets in which to invest since the ILS market came into being, with yields at very high, indeed record, levels.
Key drivers behind the current market dynamics include demand for reinsurance protection exceeding supply in both the traditional and ILS markets. Higher interest rates are also contributing to yields – the vast majority of ILS investments earn an interest rate-related return on the invested capital in both cat bonds and private ILS.
With securitised credit, Abbott said that investors can earn an 8 per cent yield on an AA-rated investment grade portfolio with zero duration and little correlation to corporate bonds.
Securitisation involves bundling the cash flows from various loans, such as mortgages, car loans and credit card payments, into bonds. The largest securitised sectors are mortgage-backed securities and asset-backed securities.
“Amid a challenging economic backdrop and the rising risk of recession, it’s worth noting the low volatility and defensive qualities of sustainable infrastructure,” Abbott continued. The benefits of investing in infrastructure have also been highlighted by other investment managers. See here. Abbott believes that the sector offers more stable earnings growth, lower price volatility and better long-term Sharpe ratios, a measure of risk-adjusted return.
A renewable infrastructure strategy involves investing in listed equity of economic infrastructure owners that are aligned to the UN Sustainable Development Goals (SDGs) and/or contribute to an environmental objective. There is a focus on regulated utilities – electricity and water networks, low carbon transport (rail) and telecoms (towers).
“With higher inflation seemingly here to stay, the inflation-hedging elements of infrastructure come to the fore. Companies are generally able to pass the impact of inflation through to the costs of their services, often with a debt cost pass-through. The sector typically outperforms during period of higher inflation, even if inflation is falling,” he said.
Abbott thinks that listed infrastructure also provides a liquidity benefit versus unlisted infrastructure, as well as a valuation arbitrage opportunity. “Annual spending in the water, rail and telecommunication infrastructure sectors also needs to increase by more than 15 per cent from current levels for targets laid out by the UN’s SGDs to be achieved.”
Abbott also thinks that investment spending levels have reached an inflexion point, driven by systems struggling to accommodate dramatic transformational changes, such as the energy transition, pollution control, growth in streaming and AI. This inflexion is most dramatic in electricity transmission spending.
“The need for infrastructure investment is forecast to reach $94 trillion between 2016 and 2040, with a $15 trillion investment gap. Electricity, telecoms, rail and water sectors are expected to account for over 60 per cent of the required investment,” he added.
Abbott sees equity call overwriting as a powerful income tool with right now being a good opportunity for these types of strategies. “Firstly, call overwriting strategies can add value to equity portfolios when markets are moving down, sideways, or rising more slowly. And secondly, call overwriting strategies are effectively sellers of volatility, which tends to increase during periods of uncertainty.”
Covered call overwriting involves selling a call option on a stock or index that an investor owns. When selling out-the-money call options, the seller retains the potential capital growth up to a certain level (the strike price), but potential growth above that level (over a set period of time) is sold in exchange for an upfront payment. (Selling out-of-the-money means the underlying price of the share or index is below the strike price at the point at which the option is sold – thus the fund still benefits from any share price growth up to the strike price).
“In this way, a call overwriting strategy exchanges some potential share price growth for the certainty of an income payment now. This exchange makes such strategies structurally different to pure equity funds, and means that when markets are rising strongly, we would typically expect the strategies to underperform the same equity model without options,” Abbott continued.
“Over the past couple of years, these strategies have been able to deliver on their income requirements, while also seeing either additive performance from the options or strong participation in the equity upside when markets have rallied,” Abbott said.
For instance, if an individual wants to invest in income paying stocks using a call overwriting strategy in the US, they can earn a dividend yield of 5 per cent vs the index yield of 2 per cent. Stocks within an income generating strategy that don’t pay any dividends can also be held, and still generate a yield, such as holding the big US tech stocks at market weight, Abbott concluded.