Unless you have a reliable crystal ball, there are many aspects of the future which are currently highly uncertain. One element of investing, however, is now clearer. Generating future income from assets will be extremely challenging and the result will see investors being pushed into riskier areas of the capital markets.
Historically, investors could rely on bonds for income. But with central banks reducing interest rates to record lows, to fight the economic effects of Covid-19, yields of government debts have plummeted. Since the start of 2020, UK 10-year gilts yields have declined from (an already low) 0.82% to 0.19%. However, we could see yields fall even further with Japan’s 10-year yield only 0.02% and Germany’s -0.42%.
At the same time as low interest rates being bad for investors seeking income, there is the additional challenge of attempting to predict how long these conditions might last. The US central bank has forecasted to keep rates at 0.25% until 2022 and will likely only marginally increase them when it does. Having said this, it’s worth noting that Japan has kept its rates at close to 0% since the 1990s, demonstrating that countries can support a low rate environment for an extended period of time.
Bonds provide investors with income but they also offer another key component of portfolio construction in the form of diversification, which acts as a hedge against equity risk. However, with such low yields available, investors needing to hit a return or income target will struggle and will be forced to look elsewhere.
There are two ways investors can generate more income in a low yield environment:
- Take additional credit risk by lending to riskier companies.
- Extend duration by lending for longer periods.
Taking additional credit risk could involve allocating to high yield bonds. However, these are generally highly corrected to equities in periods of market stress, which is when investors need the fixed income diversification benefit. Due to Covid-19 and its economic implications some commenters are saying 10% of the high yield market could default, which is a significant risk to investors.
The problem with extending duration is that with interest rates at already historic lows they have more room to increase and cause losses. This asymmetric risk profile means extending duration has more downside risk than upside.
An alternative solution would be to allocate to Multi-Asset Credit funds. These funds take a highly diversified approach, investing across the credit universe, and can adjust their duration depending on market conditions. These strategies aim to provide low correlation to the wider fixed income market and are an attractive solution for pension schemes.
Trustees will need to work with their advisors to ensure their asset allocation remains suitable and also that income needs are met in light of the low yielding environment, which may be with us for some time.