The recently elevated volatility is likely to continue in 2019. Despite the US Federal Reserve toning down its rhetoric in recent weeks, the world’s central banks remain on the path to normalisation. Traditional sources of quality income are at depressed levels as post-crisis expansionary monetary policy has driven yields to historically low levels.
But although higher rates imply higher income generation as yields rise, we have not seen income from coupons keep up with the rise in rates. While it has improved over the past year, coupon income is much lower today than it was back in 2013 when yields were at a similar level.
Source: ICE BofAML US High Yield Constrained Index, Bloomberg, December 2018.
Why do higher yields not translate to higher income? And what does this mean for income portfolios moving forward?
To explain this, it is worth disaggregating the yield on these assets into their component parts, the principal and the coupon. As rates have begun to rise, existing bonds have re-priced downwards. But as yields represent income as a percentage of the price, falling prices have increased yields without coupons rising. While new issues offer higher coupons, they do not come without risk and require due diligence before investing.
An investor can try to earn higher yields by allocating new capital to an asset class. One example could be allocating capital from lower yielding assets such as European high yield and equities, to areas such as Asian high yield, which we believe offers value in the form of higher yields and improving fundamentals.
But sometimes investors may end up allocating from higher quality to lower quality assets. We remain cautious on investment grade bonds given the rapid growth of the BBB market, which has been driven by both new issuance as well as downgrades. With spreads continuing to widen between BBB issues and their higher quality investment-grade peers, we are very wary of chasing higher coupon income at the expense of moving up the risk spectrum.
Capital preservation is as important to long-term returns as income generation. If the search for higher coupons results in holding bonds that default, it would obviously be counterproductive. Hence, we remain biased to high quality issues and don’t sacrifice quality for higher coupon income.
As we start what is set to be a challenging year for markets and income investors, and rates move further along the path to normalisation, we remain focused on how to both deliver income and protect capital.