Investment income provides many benefits – including guarding against inflation – but today’s “safe” bonds may offer no or ultra-low returns. We suggest investors hunt for income among “riskier” income generators like corporate bonds, emerging-market debt and dividend-paying stocks.
Inflation is an overlooked risk that can feel higher than official inflation numbers – but even 2% annual inflation can reduce purchasing power by almost 20% over 10 years
Slow economic growth and low interest rates mean market returns – beta – may also be low; this underscores the importance of taking enough risk to earn a sufficient return
Many "safe" bonds offer zero or ultra-low returns – and now that most central banks have stopped raising rates, easy and attractive cash returns are hard to find
Investors who “hunt for income” using riskier asset classes may be able to fight off inflation, stabilise returns and reduce overall portfolio volatility
An active approach to income investing can help investors search for opportunities and manage a broad range of risks
Today’s investors can feel inundated with information about all the ways their portfolios can be derailed – including a steady drumbeat of geopolitical crises. In our view, many of these risks will ebb and flow over time, and they are often binary: they either happen or they don’t happen. As a result, they can be difficult to hedge or invest around.
A less discussed danger is that these concerns could prevent investors from pursuing their long-term goals or deter them from taking sufficient risk in their portfolios. Some investors could even be ignoring serious risks that are less tangible, like climate change or inflation, but that can nevertheless be incorporated into an investment strategy.
Inflation can be a stealth threat
Given the relatively low levels of inflation in many economies, it’s understandable why it may not be at the forefront of investors’ minds. However, even small amounts of inflation can significantly erode purchasing power over time through the power of compounding. As the following table shows, a 2% annual inflation rate can reduce the value of an asset by nearly 20% in just 10 years. This is a clear example of why taking insufficient risk in low-return investments can put investors’ goals at risk.
Even low levels of inflation can have a big effect over time
Cost of 2% annual inflation
Source: Allianz Global Investors.
While official inflation measurements like the consumer price index (CPI) may be low, they also have inherent limitations and fail to capture the real-world experience of many consumers. In many parts of the world, health-care expenses, education costs and real estate are climbing faster than the official 2% inflation target of most major central banks. Moreover, many governments are actively trying to push inflation even higher than 2% to help them pay down their debts. US Federal Reserve governors recently suggested that they might let inflation in the US “run hot”.
Why it’s important to hunt for income
To combat inflation, investors can use several approaches. Capital appreciation from equities and other real assets can be a good inflation-fighting tool, but those returns could take time to materialise. These assets can also be subject to rapid drawdowns similar to what the markets experienced in the fourth quarter of 2018.
A steady income stream, on the other hand, can be more tangible, helping to stabilise returns and make them more predictable. Moreover, the historically lower risk profile associated with income-generating investments might help reduce portfolio volatility in times of market and economic stress.
So where can investors hunt for income today? One option is government bonds – sometimes called sovereign debt – which are among the "safest" kind of income-generating securities available. But recent data by Bloomberg show nearly USD 10 trillion in negative-yielding bonds on the market, much of which is sovereign debt that we believe is unlikely to deliver a positive return.
Fortunately, there are other types of securities – including corporate bonds and equities – that may be able to generate higher levels of income in exchange for certain additional risks, and each one provides access to different parts of the corporate capital structure.
For example, the same company could theoretically issue corporate bonds, convertibles, stocks and high-yield bonds. The ability to choose where to invest along the capital structure lets investors choose which risks they are prepared to carry – while helping them target a desired level of income potential.
Income potential can be found throughout the capital structure
Type of income-producing investment
Generally lower risk with lower income potential
Sovereign bonds from developed countries
Short-duration bonds and floating-rate notes
US corporate bonds
Generally higher risk with higher income potential
Bonds from emerging-market countries
Source: Allianz Global Investors.
Using an active approach to help manage risks
Although there are many ways to generate income, there is no “one-size-fits-all” solution for any investment strategy. As the accompanying chart shows, it is impossible to predict which assets will outperform at any given time. Investors should diversify across asset classes to help capture opportunities. This is where an active and global approach can help, since active managers can dynamically research and analyse these complex issues.
Market returns turned broadly negative in 2018
Real annual returns of major asset classes (2008 to 1Q19)
Source: Allianz Global Investors Global Economics & Strategy, Bloomberg, Datastream. Data as at 31 March 2019. US: United States, Chi: China, Ger: Germany, UK: United Kingdom, EMU: euro zone, EM: emerging markets, Jap: Japan, eq: equities, sov: government bonds, IL: index-linked bonds, IG: investment-grade, HY: high yield, Comm: commodities, HC: hard currency bonds, loc: local markets. All returns are calendar year except for 1Q 2019. Diversification does not ensure a profit or protect against a loss.
Similarly, just as all investing invites some degree of risk, there are certain risks that can affect income-generating securities, including:
Interest-rate risk: when rates rise, a bond’s value generally falls
Credit risk: issuers could default on paying income or repaying principal
Inflation risk: reduces purchasing power over time
Liquidity risk: it could be hard to find a buyer or seller at the right time
Here too is where active management may be beneficial. At Allianz Global Investors, we take an exclusively active approach to the investment strategies we manage on behalf of our clients. At the core of our process are our global credit and equity research capabilities, which help us assess potential risks and returns across a company’s capital structure. We also gain real-world insights into the issues affecting companies and consumers from our Grassroots® Research team – our proprietary in-house market research division.
With lower beta returns (what the broad market provides) likely for the next 10 years, we believe that investors should pursue alpha – or returns in excess of the market. Investors who successfully hunt for income can help protect their portfolios’ purchasing power, seek acceptable returns and aim to reduce overall risk levels during uncertain times.
This is the first in a series of pieces on the importance of income from our team of strategists, economists, CIOs and portfolio managers. Check back for periodic updates on this timely topic.
Grassroots® Research is a division of Allianz Global Investors that commissions investigative market research for asset-management professionals. Research data used to generate Grassroots® Research reports are received from independent, third-party contractors who supply research that, as far as permissible by applicable laws and regulations, may be paid for by commissions generated by trades executed on behalf of clients.
Investing involves risk. There is no guarantee that actively managed investments will outperform the broader market.The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.
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Thanks to positive macroeconomic news, China’s resilient growth and room to cut rates in India and Indonesia, the outlook for Asia-Pacific risk assets is good. Corporate bonds, emerging-market debt and dividend-paying stocks can play a critical role for investors in search of income potential.
“Riskier” assets in the Asia-Pacific region offer attractive income potential for investors dissatisfied with the returns of traditionally “safe” bonds
After a tough 2018, Asian risk assets have been supported by Federal Reserve policy, easing US-China trade tensions and stabilising growth in China
China’s growth outlook is positive for Asia overall and should help the region’s equity markets, including dividend-paying stocks
India and Indonesia have room to cut their policy rates, which should help their bonds