Striking a prudent balance between income and risk requires a combination of traditional and non-traditional investments, according to Justin Christofel, US-based portfolio manager for BlackRock’s Multi Asset Portfolio Strategies Group.
“Finding attractive sources of income is no longer as easy as it once was, with investors increasingly needing to take greater levels of risk to achieve the same returns. For those concerned with capital preservation, this can be an alarming prospect.
“Traditional fixed income yields are on average less than half their pre-global financial crisis (GFC) levels, and the question for investors and advisers is how can they construct portfolios to meet dual income and risk requirements.
“The universe for yield has shrunk. Investors today are taking on two to four times the amount of risk they were a decade ago to generate the same levels of income.
“In 2007, 100 per cent of the global fixed income market yielded over 4 per cent. Today, it is closer to just 20 per cent, and those higher yielding options are concentrated in the riskier end of the emerging market and high yield sectors.
“That is quite a bit of risk for investors to take on to generate the required yield, particularly when it is considered that these sectors exhibit significant left tails in market downturns. In other words, when markets go bad, these investments tend to do significantly worse.
“It is important to be mindful of where you seek yield, particularly if capital preservation is a portfolio objective.”
Mr Christofel said many investors have turned to Australian equities for their income needs in recent years, but the sustainability of future dividends is under question and there is also a concentration risk to consider.
“The top five stocks on the ASX represent 30 per cent of the market capitalisation and provide 40 per cent of the overall yield.”
But a flexible approach can help balance the trade-offs between yield and risk, Mr Christofel said.
“Investors can’t just think of diversification in terms of asset classes, they also need to think about it in terms of risk factors.
“In the current global environment, there’s a lot more value on the credit side of the opportunity set than the equity side.
“Non-traditional credit can be a strong diversifier in a portfolio of high yield bonds and equities.
“In our portfolio we have been trying to build and diversify away from corporate credit risk and are moving towards real estate related debt securities. That’s an area that we really like fundamentally.
“The four sleeves of our strategy in this space include non-agency mortgages, collateralised loan obligations, commercial mortgage backed securities and preference stock.
“Although some of these are considered high risk, it is possible to access segments of these markets in a high quality way to provide a consistent return stream.
“That means you will give up some yield relative to a pure high yield exposure – which is going to include some of the riskier more distressed parts of the market – but with our strategy we think that is a good trade off.”
A multi asset portfolio most also include equities and Mr Christofel said the strategy uses covered call writing to generate further risk adjusted returns.
“In the equity space, covered call writing is another way that BlackRock generates attractive income and risk adjusted returns in its Global Multi Asset Income Fund
“Investors benefit from the appreciation of the stock to a certain point, and then don’t benefit any longer. But if the stock goes down in value, you generate an incremental income in return.
“A covered call strategy in this environment is pretty attractive because of where we are in the global equity cycle. We think equities are fair to maybe a little bit expensive, and on a forward-looking basis you shouldn’t expect meaningful upside or a double digit return.
“That’s a great environment to be selling away some of that upside to generate an income return.
“And it has become an increasingly important part of how we generate income at reduced level of risk.”
