The Power of Income 1

A timely reminder about what really drives fixed-income returns and where the opportunities lie. In short: never underestimate the power of income.

With yields currently at historical lows, it’s increasingly common for investors to look for ways to use fixed-income as a reliable source of total return in their broad investment portfolios. In this paper, Product Specialist Robert Abad provides a timely reminder about what really drives fixed-income returns and where the opportunities lie. In short: never underestimate the power of income.

Assess the Landscape

Over the past 30 years, yields across global government bond and credit markets have fallen to very low levels. Not surprisingly, coupons across the major fixed-income asset classes have followed suit. The following two charts show how the US Federal Reserve’s (Fed) decision to implement an extended quantitative easing program has served to accelerate the decline in yields across a number of markets (Exhibit 1).

Exhibit 1: The Glide Path of Yields and Coupons

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

This low-yield, low-coupon environment has presented a global challenge for individual investors, pension funds and institutions who are looking for attractive sources of income or a level of return to meet their investment objectives. The challenge has become more acute due to the myriad investment opportunities now available and the inherent complexities surrounding asset allocation, market timing and risk management. This is not to claim that investors cannot find attractive yield and income opportunities across publicly traded credit markets. Indeed, if investors are willing and able to assume greater risk, higher yields can be found in alternative markets such as private debt, real estate and hedge funds to name a few.

Reaching for yield, however, can be a risky and short-sighted proposition. With each passing year, investors have become increasingly wary about loss of capital (drawdown risk), see-sawing returns (volatility) and the inability to quickly redeem their investments (liquidity risk). These concerns are warranted based on recent market experience. Over the past two years, global financial markets have been roiled by market-moving events such as Brexit, fears of a China slowdown, oil market volatility and the possibility of an aggressive path of Fed rate hikes.

Given the prevailing environment and the likelihood of more market turbulence ahead, what should investors expect regarding fixed-income returns and where can attractive income-generating opportunities be found?

Focus on the Math

To gain some perspective on where fixed-income returns may be headed, we examined the drivers of historical returns for various fixed-income sectors over a 30-year period, and the years following the 2008 financial crisis. Based on our analysis, it is clear that coupon income is the most significant contributor to returns over both time periods (Exhibit 2). If these results are surprising, then this analysis should serve as a timely reminder that: (1) coupons are a function of yield upon issue, therefore we can conclude that the yield offered by an investment will have a significant impact on the total return to be generated by the investment over its life, and (2) coupon reinvestment plays a critical role in overall total return performance.

Exhibit 2: Drivers of Historical Return

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The role of coupon reinvestment should not go underappreciated. Using high-yield as a proxy for all of the higher-yielding fixed-income opportunities, we can see how the decision to reinvest the higher level of income offered by this asset class—despite its price volatility—dramatically impacted cumulative and annualized returns over a specific time horizon (Exhibit 3). The same dynamic can also be observed, albeit to a lesser degree, within US investment-grade credit.

Exhibit 3: The Power of Coupon Reinvestment

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Needless to say, this type of analysis is highly dependent on one’s entry point into an asset class. For example, we selected June 2007 (the first month of the ensuing 2008 financial crisis) as the start date of a hypothetical investment into the US high-yield and investment-grade markets. As Exhibit 4 illustrates, income generation in both fixed-income asset classes was more than sufficient to overcome the negative drag from price return over the period and produced (especially in the case of US high-yield) a competitive annualized return versus the S&P 500 (including dividend reinvestment). This showcases the power of compounding interest which should be attractive to any investor seeking steadier, long-term total returns.

Exhibit 4: The Power of Income

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Of course, investors would need to embrace the volatility associated with their fixed-income holdings to reap the benefits of reinvestment income. In this regard, investors would have to pursue an investment strategy similar to the concept of dollar-cost averaging. For instance, if bond prices decline (yields rise), the income distributions received will buy more bonds. Alternatively, if bond prices rise (yields fall), the income received will buy fewer bonds. Over time, this approach should tend to reduce the cost basis of the investments held, minimize the impact of timing and enhance total return for the long-term investor.

Expand Your Opportunity Set

In recent Western Asset papers, we’ve noted that the global fixed-income market has grown dramatically over the past 20 years due to a number of secular forces and that it now offers investors a much richer universe of investment opportunities across a number of regions, sectors and currencies. In developed markets (DM), the opportunity set has expanded significantly to include corporate debt across the whole credit quality and maturity spectrum, bank loans, mortgage-backed securities (MBS), securitized assets, covered bonds and private debt. In emerging markets (EM), newer asset classes such as “frontier market” debt, corporate credit, local currency-denominated government debt and inflation-linked notes comprise a greater bulk of trading activity. We believe that as time passes, the breadth and depth of the global fixed-income market will continue to attract more interest from retail and institutional investors as they begin to understand the opportunity cost of not diversifying globally.

Exhibit 5: Yield-to Worst vs. Historical Correlation—Last 10 Years

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Yield and volatility statistics reflect U.S. dollar hedged data. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

That stated, investors who have a long-term horizon and are looking to generate high returns should not be seduced by the siren song of esoteric asset classes, highly concentrated sector-specific strategies or any strategy that would only work in a single macro scenario. This, in effect, would expose the investor to more drawdown, volatility and liquidity risk. Rather, we suggest using a multiple diversified strategies approach that should benefit in different environments so that no one strategy dominates performance.
Exhibit 5 highlights the risk, return and correlation profile of select fixed-income asset classes. It exemplifies our view that there is enough variety of appropriate asset classes for investors to build a fully diversified portfolio that incorporates both income- (and return-) generating assets as well as defensive assets.

Search for the Right Solution

Looking to the future, we see demand for fixed-income solutions with an income emphasis growing in line with the global demand for income. First, we are in the midst of an unprecedented demographic shift across both the DM and EM worlds due in large part to the aging of populations across North America, Europe and Japan, as well as biomedical advances that continue to extend life expectancy rates globally (Exhibit 6).

Exhibit 6: A Rapidly Aging Global Population

Source: UN Population Division, as of 31 December 2017. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

This will likely have profound, long-term implications on how individuals, businesses and governments think about savings and investment.
Second, we believe that other secular forces such as the impact of rising debt levels on global growth and continued advances in technology and innovation will likely have a depressive effect on the long-term trajectory of interest rates. At present, low interest rates have left those on the verge of retirement playing catch-up with their savings, while pensions and insurance companies are challenged with identifying more attractive sources of income-generating assets to meet their future cashflow needs. We believe this challenge will become even more acute in the coming years, leading to continued demand for fixed-income to act as an income/return generator and diversifier against equity risk in a broad investment portfolio.
With this in mind, we believe that investors should look beyond traditional fixed-income strategies, over- come their home biases, and explore another solution that seeks to capture the income and return potential available across the entire global fixed-income spectrum: multi-asset credit. This approach is not generally measured against a benchmark—to offer maximum investment and risk management flexibility—and can be classified into three distinct categories by the level of return and risk it targets (Exhibit 7).

Exhibit 7: Multi Asset Credit Market Segmentation

Source: Bloomberg Barclays, Western Asset, as of 31 May 18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

In Summary

In this low-yield world, it will be difficult for traditional fixed-income strategies to deliver returns in line with historical long-term averages. Global macro and demographic conditions are shifting and different sources of broad market risk are now materializing. With this in mind, we encourage investors to consider actively managed fixed-income solutions that seek to harvest value and income opportunities across the entire global credit spectrum.