The income challenge

24 Nov 2020

4 min read

Nicole Goldberger

Head of Growth Portfolios, Investment Solutions

The multi-decade decline in bond yields across advanced economies has cultivated a new conundrum for investors: there is no longer such a thing as a positive risk-free real return, ex ante. As the desire for income generation has not waned, these circumstances have meant it is necessary to think differently when looking at the investment offerings required to meet these needs.

Adding to this challenge is the potential that government bonds will be hard- pressed to deliver the same degree of diversification benefits seen in the past two decades, in which they displayed a robust negative correlation with equity markets. This combination allowed for simple, traditional portfolio structures to have lower volatility which in turn increases the geometric return.

With interest rates essentially at this lower bound, this relationship has the potential to become less robust and reliable over time. In the short run over the next few quarters, we expect the negative relationship of 2020 to persist. As the economy continues to recover, we believe that equity prices should move upward and interest rates should gradually increase. Conversely, should another shock occur, we see US 10-year rates potentially declining all the way down to 0.2% and expect US long bonds in particular to provide some type of hedge in sell-offs.

Rolling 36 Month Values: S&P 500 with US SBBI Long Gov

A sustained acceleration in inflation that pushes the stock-bond correlation into positive territory is the biggest risk to traditional portfolios that use bonds as their primary hedge against drawdowns in equities.

A more likely risk to portfolios is that the low level of US interest rates and proximity to the zero lower bound results in a stock-bond correlation that edges closer to zero, setting up a situation in which this “safe” asset provides neither meaningful yield nor sufficient diversification.

Today’s market realities highlight the need for a more flexible multi-asset mindset to capture higher income opportunities. We recommend the incorporation of alternative diversifiers to build multi-asset portfolios, particularly private markets if you are able to relax the liquidity constraint (and meet the investor requirements of these private funds). Illiquid alternatives – private equity, property, hedge funds and infrastructure – provide not only diversification benefits, but can be structured to produce attractive, though variable, income.

By and large, alternatives have delivered compelling risk-adjusted returns and can help investors build better portfolios. Private equity has median internal rates of return above public equities over the long term; unlevered real estate looks to be between stock and bonds; and private debt markets have IRRs slightly above high yield returns.¹ While alternatives are not immune to the pressures of a low yield world, we expect their return premium relative to other risk assets to persist going forward.

¹Preqin database as of 31 December 2019.

Dry powder (uncalled but committed capital) in USD bn

There is already a significant amount of capital flowing into private equity, which covers a large number of strategies and niche markets, broadly broken into three categories: growth/ return-oriented strategies, debt strategies, and natural resource strategies. Public pension plans, endowments and sovereign wealth funds are expanding their allocations to alternatives. Total dry powder – the amount of uncalled, but committed capital – is now over $2.5 trillion, up over $1 trillion in the last four years.

Real estate investments historically have provided stable income returns over time, while also acting as a risk reducer in portfolios given their low volatility and low correlations to traditional asset classes. Consequently, we expect steady returns in the mid-single digits for unlevered property, with the majority of the return coming from income as well as modest capital appreciation. Another benefit of real estate is that it can act as an inflation hedge. Should inflation rise consistently above 2%, we expect real estate to perform well relative to other asset classes.

Risk and return: Historic and prospective²

² Source of historic returns: Global Equites from MSCI ACWI Index unhedged in USD terms (through September 2020). Global bonds from Bloomberg Barclays Global Aggregate Index hedged in USD terms (through September 2020). Cash from FTSE 1-Month US Treasury Bills (through Sept 2020) PE from Cambridge Associates (through March 2020). Unlevered property from NCREIF Property Index (through June 2020). Core funds from NCREIF Fund ODCE Index (through June 2020). Hedge funds from HFRI Fund Weighted Composite (through Sept 2020). Infrastructure from average of median IRRs from Preqin database for 2008-2017 period.

³ We develop 5-year expected returns in the capital markets based on current markets and our expectations of inflation, growth and the path of interest rates. We then overlay our assessment of fair value and the reversion and how quickly the market will react. From here we extrapolate to the different sectors of the capital markets.