Unchain Your Yield

What You Need to Know

Many higher-income assets, such as equities, bonds and hybrid securities, offer higher risk-adjusted returns than comparable investments with lower yields, often without disproportionate increases in volatility. But these higher-yielding assets are vulnerable to significant drawdown risks. Our research shows that an integrated multi-asset income strategy can address these asset class–specific risks while protecting against the shortcomings of bolted-together solutions. We believe this approach can help investors enjoy a better balance of income, stability and growth than more concentrated single-asset income strategies can.

Whether it’s to provide extra cash for retirement spending or as a long-term strategy to build and preserve wealth, income investors aspire to generate steady, robust annual payouts while preserving capital. This sets up a multipronged challenge: how to maintain a three-way balance between yield, stability and capital growth (Display). Emphasizing any one element in this investment triumvirate can threaten the balance of the other components of the equation.

These days, that quandary has become even more acute and vexing. Heightened market volatility, historically low interest rates and late-cycle risks after an extraordinarily long period of economic expansion have raised the stakes for income-hunting investors. Leaning into high-yield assets might enhance return potential, but could also undermine a portfolio’s stability. On the other hand, those who play it too safe will have to settle for more modest returns and lower yield.

In this paper, we examine how to carefully diversify higher-yielding assets and dynamically manage an array of hazards to help income investors capture yield while minimizing drawdown risk. The key, in our view, is to unchain a portfolio from traditional constraints, by sourcing higher-yielding securities across asset classes and around the world.

Creating a Risk-Aware Income Strategy

Many higher-income assets offer higher risk-adjusted returns than their lower-income peers. Yet higher-yielding equities, bonds and hybrid securities are vulnerable to drawdown risks that make them imprudent as concentrated or stand-alone investments. But there’s good news, too. Severe tail-risk events don’t usually hit high-income assets simultaneously, so a keen awareness of the potential threats can help investors create effective diversification.

We believe that when higher-income securities are integrated strategically in a multi-asset portfolio, they can provide a balance of income, stability and growth that should withstand the volatility and rising uncertainty in today’s markets.

Income Outlook Is Sobering

Income investors have struggled to find reliable sources of yield since the global financial crisis. Today, with government bond yields near zero, fixed-income yields are scarce. To achieve an annual yield of 4%, investors would need to take on much more volatility than a decade ago. While active fixed-income portfolios can be designed to deliver yield in this complex environment, new approaches to the income challenge are imperative, in our view.

The outlook for yield is sobering. Global macroeconomic growth is expected to be lower than historical trends as changing demographics decelerate the pace of workforce growth. Inflation is expected to be persistently lower despite central bank efforts to induce more normal inflation rates. In a low-growth, low-inflation world, interest rates are likely to remain significantly below long-term historical averages.

In this environment, we think investors looking for income should consider expanding their asset allocations (Display). This can include adding traditional equities, high-dividend equities and real estate investment trusts (REITs), as well as nontraditional sources of income such as options strategies, currency and interest-rate alpha strategies, and master limited partnerships (MLPs).

Embracing a multi-asset approach opens additional opportunities for yield and better growth potential. In fact, this paper will demonstrate that higher-income assets in equities and alternatives actually offer comparable or superior risk-adjusted returns, which are generally uncorrelated to fixed-income assets. To be sure, investments such as high-yield bonds, REITs and high-dividend equities expose investors to other equity-like risks that require careful and dynamic management. For one, the downside risk of many income assets is somewhat greater. And in certain cases, they are subject to more pronounced fundamental or structural risks that include bankruptcy, liquidity, sector-specific shocks and idiosyncratic risks. But by being alert to these differences, investors can construct multi-asset portfolios to capture the high return potential of income assets while protecting against the tails—particularly, strong downside shocks—through a variety of interest-rate and macroeconomic environments.

^*Multi-asset income allocation is 50% high-yield bonds, 40% high-dividend-yield equity, 2.5% REITs, 7.5% preferred REITs and adds duration extension with global treasuries at 20%.
^†As of December 31, 2019
^‡Dynamic multi-asset income is 35% high-yield bonds, 25% mix of global equities (tilted to complementary exposures such as high-dividend, quality and minimum-volatility equities), 10% global REITs, 20% government bonds, 5% emerging-market debt and 5% MLPs, dynamically adjusted over time.