In this series we are breaking the subject of income investing down into manageable chunks.
So far James Norton, senior investment planner at Vanguard, has explored the role of dividends and interest, and why investors tend to focus on obtaining a high income.
In this instalment he explores the risks of chasing higher yields.
Reaching for higher incomes in a low yield market does result in additional risk according to James Norton of Vanguard
The good old days
The traditional way of managing a portfolio for income was to invest in a range of equity income funds and some bonds (also known as fixed income).
The equity element usually made up around 40 per cent to 60 per cent of the portfolio.
Its purpose was to provide growth through shares that tended to pay dividends higher than the market average. The fixed income made up the balance and provided diversification and a boost to income.
This worked for many years. You could take the dividends and interest generated from the portfolio and leave the capital untouched, hopefully to grow over time.
Bond yields aren’t what they used to be
However, as shown in Figure 1, the income generated by bonds has fallen steadily over the last 30 years, leaving many of us struggling to obtain our desired income.
Figure 1: The graph illustrates the steady decline in income from bonds
To counter this trend of falling yields from high-quality fixed income, many have hunted for higher yields elsewhere.
But, like other areas of investing, there’s a link between risk and reward. Higher income can mean you are exposed to higher risk.
So where have investors gone?
An increased equity exposure
Many have increased their equity exposure. At the time of writing, the yield on the FTSE 100 is around 4 per cent compared to roughly 1.5 per cent for a 10-year gilt.
So for an investor seeking income, increasing the equity weighting may look like a dead cert. In the short-term there’s no doubt their income will rise.
However, remember what the role of fixed income is in a portfolio.
Yes, it will provide some income, but its main purpose is to act as a buffer against the ups and downs provided by equities.
When shares fall it’s high-quality fixed income that protects the portfolio. High-quality bonds tend to rise in value as equities fall because they benefit from a flight to safety.
If you’ve reduced your fixed income exposure, your portfolio won’t benefit from this diversification, so it’s highly likely to suffer when stock markets fall… and that means lower total returns in the long-run.
Bonds are not risk-free
As we are on the subject of bonds, it’s worth reminding ourselves about risk again. Once you move away from high-quality bonds to increase income, so the risk increases.
For example, in the same way that a small overseas bank operating in the UK may have to offer a high rate of interest to attract depositors because of the perceived risk, so does a higher-risk company when issuing bonds.
Remember, bonds are just another way that companies can borrow money. So if the yield or income on one bond is higher than another, that’s for a reason.
In recent years, income seeking investors have been attracted by high yield bonds, emerging markets bonds and strategic bond funds (where the manager attempts to increase yield by security selection and market timing), all of which have paid a higher level of income than traditional high-quality bonds.
The problem is, these alternative bond categories tend to behave more like equities when markets fall.
So, in the periods when you need them for their capital preservation qualities, they don’t fit the bill – indeed, they can suffer sharp sell-offs. Not what you want from the lower-risk part of your portfolio.
High yield tends to mean high risk
Income seekers are not usually thought of as risk takers. But the truth is, reaching for higher incomes in a low yield market does result in additional risk. Figure 2 provides a good example. It shows how different asset classes moved during the global financial crisis, when global stock markets were falling.
Figure 2: How different bond categories performed during the financial crisis – October 2007 to March 2009
There are a few important points to note.
- Although global equities performed badly, falling 37 per cent, equity income funds fell further, dropping 47 per cent in value.
- High-yield bonds, emerging market bonds and strategic bond funds all fell in value, providing little diversification benefit.
- High-quality bonds rose in value, performing the role they were meant to do, protecting the value of your portfolio in times of stress.
The moral of this story is simple: chasing yield by increasing weightings in equities or alternative bond classes can materially reduce the diversification of your portfolio and raise its risk profile.
Next time: In part 4, we will look in more detail at how Vanguard thinks about managing a portfolio for a sustainable income that won’t increase your risk.
Until then, remember to have reasonable expectations in terms of what your portfolio really can deliver.
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