Many market commentators have warned investors they face significant losses on their income portfolios as yields around the world begin to rise from record lows.
Their warnings gained some validity when bond yields surged after the nomination and election of Donald Trump as US President late year. The bond-yield surge was dubbed the ‘Trump Tantrum’, a nod to the 2013 ‘Taper Tantrum’ yield-surge when investors began to fret about rising US rates.
The warnings have frightened investors and clients reliant on income portfolios to fund their lifestyles, particularly retirees. Will income funds be able to deliver in this new risk environment?
AMP Capital’s Matthew Hopkins, who manages the AMP Capital Income Generator, says there was risk in fixed income and bonds, which as an asset class has been expensive. Post-global financial crisis stimulus had pushed bond yields to unprecedented lows. Late last year the Australian Government 10-year bond yield fell below 2 per cent for the first time, while some yields in the likes of Germany, Japan and France fell below zero.
Investors could suffer big losses when interest rates rise. Investors seeking a defensive safe-haven in fixed income heightened those risks. “If everyone jumps out they could exacerbate any sell-off,” Hopkins says.
But Hopkins believes there is no reason for income-focussed funds to lose performance if they adopt appropriate defensive strategies and tactics, and continue to seek out opportunities. “Our focus in on delivering investors a cheque every month,” he says. “The way we have positioned the portfolio means we believe we’re resilient in environments like this.”
Indeed, Hopkins and his colleagues at AMP Capital have long been positioning for a reversal of bond yields and scenarios like the Trump Tantrum for some time. That’s allowed the Income Generator, and AMP Capital’s other income-focussed funds to weather the Trump Tantrum and continue to meet expectations.
Late last year Hopkins stopped allocating to fixed income. That meant his fund wasn’t investing at low yields and risking losses when rates rose. Another characteristic of the Income Generator that improves its resilience: it doesn’t trade bonds. When it buys a bond, it generally holds them to maturity, and where it does so it doesn’t realise any capital losses on holdings if yields rise.
But there were five other steps Hopkins took to position the portfolio. Those steps can provide advisers with a road map on how to weather the current environment. But advisers can also use them to communicate confidence to clients around risk mitigation strategies aimed at protecting their income streams, even in difficult times.
1. Shorten portfolio duration
Hopkins’ has shortened the ‘duration’ of the fund’s bond holdings. Bonds that mature further in the future, such as 10-year bonds, fall more heavily when rates rise than those that mature in shorter timeframes, such as 1-year bonds.
He believes a tilt to shorter maturities can help protect the portfolio. The average maturity of bonds in the Income Generator funds is now close to two years. That’s significantly lower than the normal corporate bonds fund index of 6 to 7 years.
2. Reduce inflation-linked bonds and hybrids
Hopkins has taken defensive action in other parts of Income Generator’s fixed income allocation. He’s sold holdings in areas he felt the fund wouldn’t be sufficiently compensated or where he was concerned about market risks. That means he’s reduced exposure to inflation-linked bonds and completely exited hybrids.
Inflation linked bonds were reduced in the overall fixed income mix as the real yield on them was poor relative to corporate bonds. By exiting some of these bonds, the fund was also able to release income for investors.
3. Trim corporate bonds
One area of fixed income Hopkins remains comfortable with are corporate bonds. He notes that rising rates are normally an indicator of better economic growth, which is good for corporates. “Credit quality of corporate bonds isn’t under immediate pressure,” he says.
That will eventually change as rising rates start to hurt corporate earnings. “But at the moment credit quality is high” and he notes the fund’s average credit rating is currently an impressive AA.
4. Increase Australian equities
To position the fund for this challenging environment, Hopkins isn’t just being defensive.
He’s also seizing opportunities. He’s raised allocations to Australian equities. Australian Equities have benefited from improving global growth, particularly in the second half of last year. The improvement can be seen in earnings growth where the Australian market moved from a period of flat earnings in 2016 to current expectations of over 10% in 2017.(1)
5. Consider community infrastructure
And Hopkins has also introduced an investment into community infrastructure assets. In community infrastructure the fund has accessed a high-yielding but very diversifying set of assets that is relatively unique in the market place. Assets such as Royal North Shore Hospital, South Australian Schools and WA Prisons provide contractually guaranteed revenue that are normally both linked to CPI increases and backed by high-quality counterparties.
Weathering the Trump Tantrum
In the fourth quarter of 2016 the Australian 10-year bond yield rose by almost 1%, resulting in bond indices losing around 3% over the quarter. In addition, ‘yield’ focused asset classes also lagged with global listed infrastructure and real estate both losing well over 2%. (2) Income Generator performed very well through this period, gaining 2.05% (3 month return, platform Class A net of fees, as at 31 Dec 2016. Past performance is not a reliable indicator of future performance).
While interest rates have room to rise over the next few years, which will constrain returns from yield-dominated assets, economic growth is a likely backdrop to those rising rates, which will create income opportunities.
“Income Generator has proven it can negotiate different interest rate environments,” Hopkins says. “And in a world where growth should support earnings, the fund is very well placed to be a beneficiary and continue to provide solid and growing income streams to clients.”
Source (1)Citi Research. Data as at February 2017. (2) Bloomberg, AMP Capital. Data as at December 2016
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