Navigating the “new normal” for investment income

By Vincent Berard, Head of Product Strategy, BNP Paribas’ THEAM Quant Funds.

Where should fund buyers and DFMs turn as they are increasingly compelled to re-imagine income investing in a volatile market?

Over the past 12 months, many fixed income benchmarks have returned double-digit losses. With underlying inflation pressures set to remain elevated, the erosion of purchasing power is expected to remain a concern for investors.

So, what are the income investment options available for fund buyers and discretionary fund managers (DFMs) to navigate this environment successfully for their clients?

Re-thinking income investing

Income investing means selecting investments designed to deliver a steady stream of income over a certain time horizon or period. It’s a popular way to chase decent returns – and to potentially beat inflation.

There are several approaches that portfolio managers commonly use to try and generate regular income for their clients. These can be equity funds that have potential to pay out significant dividends, or bond funds that offer a fixed income from money you “lend” to the government or companies who need to raise cash.

However, the simultaneous collapse of equity and bonds in the first half of the year has highlighted the need for investors to review their asset allocation.

Additionally, with inflation rates edging higher and higher since the start of 2022, client income expectations have risen in tandem – i.e., clients want to receive a real income above inflation.

Consequently, there exists an expectation gap between increased client return objectives and current investment yields, which are simply not nearly as high as they were in the past.

So, where is a discretionary manager to look to find an opportunity set that aligns with client demand for real income in a low yield environment?

Bond replacements

There is no doubt that almost all types of investors – ranging from pension funds and insurance companies to wealth managers – are now looking for sources of regular and growing investment income. And many want this with a limited correlation to volatile equities.

We are seeing investors increasingly turn to “bond replacements”– investments offering income streams of a different nature than bonds. Solutions that answer this need will likely see increased demand for mainly two reasons:

Firstly, while bonds now offer slightly improved yields, increasing allocation and duration exposes portfolios even more to further rates rises. So, diversifying sources of income going forward should be an attractive proposition.

Secondly, investors today feel the need to keep sustained levels of risk in their portfolio (in an attempt to get it back to where it was earlier in the year) but would rather not put all this risk into equities.

This is where alternative solutions play into the hand of these clients’ return objectives.

Innovative income solutions to consider

The best of these solutions offer exposure to diversifying markets (such as commodities and volatility) and/or to diversifying strategies (including long/short, relative value and multi-strategies) – often in the form of equity solutions.

One such approach is to harness the equity volatility on display in the global markets. A popular solution among DFMs and wealth managers to seize on this opportunity is through generating income with options. Equity volatility is a risk that doesn’t look like it’s fading anytime soon, but its volatility also presents a chance to generate higher income, using derivatives as a tool.

A strategy like this can come in the form of an equity solution, but one that aims to systematically generate regular and enhanced income, with as balanced a risk-return profile as a “vanilla” equity fund.

There are many other innovative strategies with an ability to provide recurrent, real income in the current rates environment and high inflation. These approaches are proven to mitigate large market and portfolio drawdowns, whilst providing a greater level of income when equity markets are more volatile.

Others aim to generate recurrent income in bearish, as well as bullish, markets. Some even focus on extracting the carried interest from commodity futures to supplement income.

Crucially, the very best of these innovations remain cost-efficient in their design – despite employing the advantages of an “active” investing technique.

Experience counts

It is increasingly important to identify diversified sources of income beyond traditional sources – strategies that can considerably supplement an income portfolio over the next business cycle – whether it is by generating regular income with options, or extracting the carried interest from commodity futures.

However, looking beyond the “traditional” has its own risks. For fund buyers, the cardinal investment rules around track record, experience and value should be tantamount in the search for the best income solutions. Risk managed, systematic expertise like this is likely to be backed up by several decades’ worth of experience.

Once these factors have been adequately accounted for, there are certainly options in the market for DFMs seeking enhanced income solutions – the best of which can provide consistent returns despite (indeed by productively channelling) various macroeconomic risks on the table.

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