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As our subscribers know, we rate some Multi Asset Income Funds well. But, across the board, we have raised a concern with each of the managers of these funds. It is the income expectation that seems to settle at around 5%: that is to say, their fund needs to offer a 5% income yield, on average, across the fund to be competitive with peers. In a world where most bonds are yielding well under 5%, this seems an increasingly tough deliverable.
But, history is important because these income targets were often set when bond yields were a lot higher. For example, pre- Financial Crisis yields looked a lot different than they do today. If you were a multi asset income fund manager in late 2007, you had a far wider opportunity set. Cash rates were around 5% and corporate bond yields around 6%. The UK 10 year Gilt was above 4%. And, you could dip into high yield, at around 9%. Simplistically, in late 2007, it is easy to see that a multi asset income manager could comfortably build a diversified portfolio with a 5% yield target – and probably do it with quite a healthy exposure to investment grade bonds.
But, when we roll the clock forward to today, it is noticeable how narrow the opportunity set has become in those asset classes that deliver a 5% plus yield. Cash, as we know, delivers almost no yield now. We also find UK 10 year Gilts at below 2% (as an aside, UK equities are delivering around double this yield. Are 10 year Gilts, at under 2% yield, now return free risk, rather than risk free return?). We also find corporate bonds around 3-4%. Global property stocks (REITS) are also under 4%. That, pretty much, leaves high yield bonds and Emerging Market Debt as the only obvious, traditional choices that average 5% or more (high yield is around 6.6% and EM debt is around 5%).
What does this mean for the multi asset income manager that needs to average a 5% yield across the fund? The obvious point is that the yields they need are no longer readily available within those assets with a higher degree of capital protection (cash, sovereigns and investment grade corporates). They have to look elsewhere, often towards those that are traditionally more risky (high yield bonds, EM Debt). They may also need to be more creative and focus on less traditional areas like infrastructure, loans, property debt and CLO’s – and these tend to be less liquid.
We would also be concerned that diversification becomes increasingly difficult in such a world. Take corporate bonds: they offer exceptional equity diversification, whereas high yield bonds tend to add to equity risk.
We are also starting to see signs that some managers could be starting to swap capital for income. For example, we find various call option strategies in place today, where the manager is forgoing capital upside in exchange for income from call option premiums. These are, to the skeptical investor, potential signs of income being manufactured.
Are we suggesting that multi asset income funds are becoming more risky? Naturally, that depends on the one you choose. But, in the short run, with yields at these low levels, one has to assume some compromises are likely being made (to bond quality and perhaps liquidity). Their ability to diversify is also being challenged, which can cause an increase in equity type return profiles.
We should also add that, if yields stay lower for longer, the demand for income will continue to outpace supply. And a multi asset team, in theory, has all the tools to work around this problem: they should not, in theory, be beholden to any one asset class to deliver yield. This makes them a compelling income proposition, so long as the income expectation is reasonable.
When finding a multi asset income manager, we spend a substantial amount of time probing the manager on their attachment to a yield target. Are they reaching for yield or would they drop their yield target to protect capital through better portfolio diversification? We are watching this space very closely.