The search for income: Capital Group’s Ed Harrold looks at diversifying in challenging times

by | Jun 20, 2023

Analysis provided by Ed Harrold, Fixed income Investment Director, at Capital Group

The last few years have proven challenging for income investing in the UK with domestic assets impacted by rising inflation and economic slowdown. UK-based investors have traditionally turned to domestic equities, bonds and property as a means of income generation. However, with many equity dividends cancelled amid the pandemic, multi-decade highs in inflation, and central banks in rate hiking mode, these factors all created a particularly difficult backdrop for income investors, with markets experiencing one of the most turbulent periods in a generation.

These factors all serve as a reminder that if UK-based investors are looking to achieve income over the long term, they may need to look at diversifying their pool of assets. With 83%* of discretionary fund managers viewing fixed income’s role in a portfolio as one of diversification, this may well be the place to look.

Why fixed income?

Investing in fixed income during a time of a high inflation and rising rates can seem worrisome. However, today’s starting yields offer an attractive entry point for investors. Yields across fixed income sectors are sharply higher than their lows over the past few years. At current yields, history suggests higher total returns over the next few years.

This means that investors could benefit from holding bonds across fixed income asset classes, including investment grade, high yield and emerging markets. The higher income these sectors can offer provides more of a cushion for total returns over time, even if price movements remain volatile. In fact, a greater portion of investors’ income needs could potentially be met with traditional fixed income than would have been the case in recent years.

Why invest globally?

Diversification offers a range of benefits such as the possibility of a more consistent income. For example, rising political and economic risk have created a challenging backdrop for UK investors, so greater exposure to global assets could help mitigate the impact of such risks.

Gaining greater exposure to global assets also allows you to access different markets that may also be at different stages through the investment cycle. For example, having been impacted by inflation in previous decades, many emerging market central banks were ahead of their developed market counterparts when hiking interest rates following the pandemic. Although many of these countries may now be reluctant to cut interest rates before the US, their speed in hiking means they are well placed to ease policy when the Fed does pivot. In contrast, UK inflation remains significantly above the Bank of England’s target rate of 2% and the market currently expects further hikes through 2023 and 2024. Diversifying exposure across different markets allows investors access to this variation and means portfolio positioning can be tilted toward those markets where the macro-economic environment is more favourable to fixed income.

Why invest in both high yield and emerging markets?

Combining high yield bonds and emerging market debt (EMD) can bring further diversification benefits that help reduce overall portfolio risk. This could allow UK investors to cast their net wider in their search for income without taking on excessive additional risk. While it’s definitely worth considering the risks in any investment, there are several misconceptions around high yield bonds and EMD.

High yield bonds are lower quality and higher risk?

Today’s high yield market is largely made up of listed mid- and large-cap companies, and 88% of the US high yield index is rated ‘B’ and above (the portion of the universe that typically has the lowest default risk).

The overall credit quality of the high-yield universe has improved significantly as index-level ratings have become higher quality, especially post-pandemic, as a result of investment grade companies slipping into the BB rating range, while defaulted bonds have dropped out of the index. BB-rated companies now make up about half of the market, up from around one third 20 years ago.

The high-yield corporate bond market has a long-term record of producing a high level of income, which is the primary contributor to its total return over a full market cycle. The sector is large, at about $1.5 trillion – approximately triple the size of the combined value of the UK sterling investment grade and high yield markets- and spans a multitude of industries and issuers. This market depth brings the benefits of both liquidity and the ability to build a well-diversified portfolio.

With yields above 8% and spreads in the mid-to-high 400 bps, investors with a three-to five-year time horizon could experience returns in excess of historical high yield annualised returns. While uncertainty remains, current valuations have priced in negative sentiments. Downside risks could prove to be short lived and drawdowns lower than those experienced in previous cycles given the higher quality and stronger fundamentals in today’s high yield market.

What about EMD?

Again, the perception is that these are higher risk markets. In fact, many emerging economies have lower government debt-to-GDP ratios than advanced peers, as well as lower levels of corporate and consumer debt.

To add to that, we have seen an improvement in emerging market creditworthiness as they have moved towards flexible exchange rates, foreign exchange reserve accumulation, lower external deficits, and an increased share of debt issued in local currencies. Around 75% of local currency sovereign bonds are investment grade, while hard currency sovereign bonds have an average credit rating of BB+ which is the highest credit rating for high yield bonds.

Although there is increased risk with high yield and EMD, we believe that many characterisations of these markets are outdated and don’t consider the transformations that have taken place over the last 30 years and warrant a reconsideration. With UK-based investors finding traditional options more challenging, diversifying may help to support more consistent income generation and allow access to greater opportunities.

Despite the challenge faced by fixed income assets over recent years, our research* has revealed that 60% of UK IFAs still anticipate an increase in confidence in this asset class during 2023. It is our view that fixed income will continue to play a hugely significant role in investors’ asset allocations over the coming years, providing a valuable source of diversification, income, inflation protection and capital preservation, all of which will of huge importance to investors within the current market environment.

  1. * According to research conducted by ‘Research in Finance’ as a two-stage study comprising quantitative and qualitative elements. The quantitative fieldwork entailed an online survey of 277 financial intermediaries carried out on 7 – 22 November 2022, which was followed by the qualitative fieldwork including nine online interviews with DFMs and two online focus groups of six IAs conducted from 24 November to 2 December 2022.

About Edward Harrold

Edward Harrold is an investment director at Capital Group. He has over 15 years of industry experience and has been with Capital Group for ten years. Prior to joining Capital, Edward worked as an associate in RBS Global Banking & Markets at the Royal Bank of Scotland. He holds a bachelor’s degree with honours in international relations from the London School of Economics. He also holds the Chartered Financial Analyst® designation. Edward is based in London.

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