Investment Clock insights

Are investors over-reaching for income as the hunt for yield continues?


Trevor Greetham

13 August 2015

First featured in Investment Week, 11 August 2015.

The low interest rates and annuity rates of recent years have triggered the launch of a proliferation of multi-asset income funds investing, often somewhat indiscriminately, in any asset class offering a high enough yield to pass muster.

Neither these funds nor, in many cases, the managers that run them have been tested in a proper market downturn or a period of rising interest rates such as the one we expect to start later this year.

High income levels are associated with high risk of capital loss. Drawdown facilities that allow you to cash in fund units mean you do not need to invest in risky assets to draw an income to live on.

You do not even need to invest in assets that pay an income. Taking regular drawings from a low volatility multi-asset portfolio as part of a planned strategy is just as good for a stable income strategy.

There is a widespread and misplaced belief that it is prudent to take only income from your investments in order to keep the capital intact. Yet market forces over the past eight years have changed things. Inflation and long-term interest rates have been falling in the developed economies since the early 1980s.

A bond bull market that was initially powered by tight monetary policy and the adoption of inflation targets was super-charged from 2007 by the deflationary forces the financial crisis unleashed.

Central banks slashed rates to zero and bought billions of dollars of government securities from the market to prevent a bank credit implosion.

As a consequence, the real interest rate on index-linked gilts has been negative for more than three years and developed economy governments can borrow long-term money at a rate below central bank inflation targets without offering protection from inflation. For investors, risk-free return has become return-free risk.

Too much risk

Unconventional monetary policy was intended to boost the economy, in part by forcing investors out along the risk spectrum and, in doing so, lowering the cost of capital for companies and raising asset prices to boost consumer confidence. The policy has certainly worked.

With paltry rates on offer from national savings products, some investors – including a new breed of 'multi-asset income' fund managers – are queuing up to buy a bewildering range of high yielding investments linked to the likes of toll roads, aircraft leasing companies and emerging market farm land.

These investments are often packaged up within specialist structures by investment banks who, in an echo of the sub-prime lending fiasco, are rubbing their hands in glee at the ease with which they can sell on otherwise illiquid assets with few questions asked.

Investors who have been reaching too far for yield may suffer from capital losses and a sudden and potentially permanent lack of liquidity as rising interest rates attract capital back into government bonds. As Warren Buffet said, only when the tide goes out do you discover who has been swimming naked.

High risk

There is a widespread and misplaced belief that it is prudent to take only income from your investments in order to keep the capital intact. But high income often means high risk.

To take an extreme example, no one would plan a retirement strategy on the basis of the 25% income on offer from Venezuelan government bonds without considering the troubled sovereign may not pay the loan back in full at the end of the term.

Things that seem too good to be true generally are. The trouble today is what may seem like a reasonable level of income to demand by the standards of years gone by, now includes a wide spread over government yields to compensate for the risk of default.

In other words, the risk is higher for the same level of income. And when interest rates rise and balance sheets become stressed, many investors will be heading for the same narrow exit door.

These days you do not need to invest in income generating assets to generate an income from the fund you own. Take a planned 'decumulation' strategy, cashing in units from a well-diversified multi asset fund rather than relying only on payouts of income flowing from underlying investments.

Dipping into capital can be entirely reasonable, especially if you are able to reduce withdrawals when the markets are down. So a multi-asset fund would include fixed income assets to dampen volatility but with duration and credit exposure carefully managed.

Moreover, such a fund would include exposure to asset classes like equities, commodities and direct property that often offer positive total returns while bond yields are rising.

You should not have to take undue risks to draw an income to live on.
The value of your investment and the income from it is not guaranteed and can fall as well as rise. This article is for professional customers only. The views expressed are the author’s own and do not constitute investment advice.