Sources of Income, their importance and risks
Whether investors seek yield primarily for cashflow requirements or for use as a component of total return, the dependability of the income streams from, and the capital risks associated with the assets they buy matters.
Whether investors seek yield primarily for cashflow requirements or for use as a component of total return, the dependability of the income streams from, and the capital risks associated with the assets they buy matters. Over the last 20 years, income has accounted for 90% of total returns from major asset classes. In some cases, it has accounted for more than 100% of returns with asset classes such as high yield debt seeing capital value erosion after income. In the short-term, the predictability of an asset's income stream may seem high.
Typically companies set days for the declaration and payment of dividends, while coupon bearing bonds have a schedule of payments. Investors, however, should focus on the enormous variability of longer-term income sustainability between and within asset classes and the capital risks which can dwarf the benefits of the income received. Here we describe some of the commonly available sources of income, the risks associated with them, and how to combine them for a robust income stream.
A reliance on 'natural income'
Over the last 20 years, income has accounted for 90% of total returns from major asset classes. In some cases, it has accounted for more than 100% of returns.
The Investec Diversified Income Fund has achieved its three objectives of defensive returns, an attractive and sustainable yield, and volatility less than half that of UK equities by focusing primarily on 'natural income'. Selling options is one method that can occasionally be an attractive means of generating synthetic income, however, we do not think it is wise to employ it throughout the cycle. Call overwriting works by selling call options in exchange for a 'premium'. This entitles the purchaser of the option to buy the underlying asset from the option seller should its price rise to the 'strike' (the exercise price).
The amount of 'premium' generated is dependent on factors such as the distance between that strike price and where the asset currently trades, the amount of time left until the option expiration and the asset's volatility. The last of these is a key reason why we don't think this source of synthetic income should be relied on throughout the cycle.
There are points in time when the risk/reward profile of selling an option may be attractive, for example if volatility looks excessively high. However, to engage in options selling simply for income generation risks exposing the investor to capital losses that exceed gains (particularly if offsetting assets are not owned or if they perform poorly). As a result, this strategy should be approached with caution and with an awareness of the cyclical environment.
Growth, Defensive and Uncorrelated income streams
Investec's Multi-Asset team categorises assets according to their behaviour relative to the cycle. An asset can be Growth, Defensive and Uncorrelated (Figure 1) and this applies equally when we think of income streams.
Figure 2 shows that while the volatility and yield (the size of the circle) varies considerably by behaviours (Growth, Defensive and Uncorrelated) they are relatively close in terms of their significant proportion of total returns explained by income.
Figure 2: Income characteristics of asset classes versus behaviours
Source: Morningstar, Bloomberg, BofA Merrill Lynch, Investec Asset Management, in USD, 30.09.17. Annualised standard deviation of monthly returns over 3 years. Investment grade debt: BofAML Global Broad Market Corp TR USD; DM gov't debt: BofAML Global Governments Bond II TR USD; EM LC debt: JPMorgan GBI-EM Global Diversified; High yield debt - global: BofAML Global High Yield TR USD; Global equities: MSCI ACWI NR USD; Global property: S&P Global REIT TR USD.
Identifying, understanding and blending sources of income
We focus on having a clear and repeatable process when building the Diversified Income Fund as we seek to ensure a dependable and compelling level of income. The process involves:
- Selecting assets from the bottom-up and from a variety of asset classes by undertaking a thorough analysis of the cashflow streams of corporations and governments, and the accompanying risks to capital.
- Understand the likely behaviours of selected assets, and holding a diversity of Growth, Defensive and Uncorrelated assets.
- Hedging drawdown risks by using the holistic understanding of the portfolio from the bottom-up and top-down to efficiently protect against losses.
The result of this process is a diversified series of contributors to the Fund's distribution yield.
This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale. The full documentation that should be considered before making an investment, including the Prospectus and Key Investor Information Documents, which set out the fund specific risks, is available from Investec Asset Management. Bond and Multi-Asset funds may invest more than 35% of their assets in securities issued or guaranteed by an EEA state. Inc-2 share class expenses are charged to the capital account, so capital will be reduced and any income payments will be increased to an equivalent extent. This could constrain future capital and income growth. Income may be taxable.