Equity income managers have seen their universe shrink. Bond yields are at record lows, spreads are unattractive in investment grade, high yield is expensive and rewards for emerging market debt do not justify the risks.
Investors may feel the need to take more risks, perhaps in more esoteric asset classes, to achieve the same income stream. This can lead to both increased liquidity risk and volatility. Investors who desire income should appraise any headline yield against the plethora of risks, some of which may not be immediately obvious.
Should they go for headline numbers or a sustainable yield? The hunt for yield seems ever more difficult. Most asset classes are unattractive from a valuation perspective and, with equity markets edging to all-time highs and many income stocks on premium valuation, investors are struggling.
Global equity income managers talk of their dilemma when seeking interesting opportunities as bond yields continue to fall. Although dividend yields are on the face of it higher in emerging markets, this is not the case when we apply what we consider to be an appropriate discount rate for political risk and currency risk. While we remain positive on US equities, a dividend culture is not embedded there; many corporates are growing dividends but not enough to offset share price rises, and a significant proportion of corporates prefer share buybacks. Although the US is 55 per cent of the global index, only one-third of total dividends stem from the US.
Within government bonds, one must take a great deal of duration risk to achieve a positive yield, so this asset class remains unattractive. One can achieve positive real yields in emerging market debt but, again, this asset class is unattractive in spite of the low valuations, due to falling GDP growth in China and Latin America. Furthermore, these markets are seeing investment outflows, increasing the risk of currency depreciation.
In the high-yield space, implied default rates have increased to 2 per cent above their historic average, so there is more value there. However, there are concerns about the significant percentage of the US index in energy names; more than 10 per cent of the US high-yield sector is in energy and vulnerable to falling oil prices.
In property, there has been significant yield compression, with offices in Birmingham yielding the same as their London peers. Net asset values in the secondary property market are more correlated with equity markets. This leads on to a broader trend of more esoteric asset classes that are being marketed for yield. These include the likes of distressed debt, student accommodation, aircraft leasing, caravan parks and litigation funding.
Some opportunities might look attractive, but come with dangers such as increased liquidity risk, higher drawdown potential and quasi-sovereign credit risk. Investors should appraise whether the yield and total return they expect is sufficiently rewarding for the risks they may be taking.
Given the environment, the sustainability of the yield should be scrutinised over and above the headline number; after all, the yield is a ratio that is relative to the spot price. This is but one argument for prioritising yield sustainability and the total return.
