Capital Group discusses the search for yield in the post-financial crisis period and why it is a good time to own financial assets.
Demand for “income opportunity” funds has risen significantly since the Global Financial Crisis on the back of extraordinary central bank stimulus, which suppressed real yields and compressed risk-premia across asset classes.
Simply put: the post-financial crises period has been a great time to own financial assets, especially the less liquid or deeply distressed ones.
However, as central banks withdraw accommodative policies, and investors seek more liquidity, it could be time to reassess approaches to constructing income opportunity portfolios. In particular, we believe it is crucial to identify those strategies that could provide value in changing market environments.
Ticking both boxes
There are several approaches to constructing “income opportunity” portfolios across the investment landscape. Some strategies seek to employ leverage to enhance returns, while others choose to source income-generating ideas from relatively less liquid asset-backed products.
Yet, investors can also take a middle-ground approach and look to reduce risk without forfeiting income and liquidity. By blending emerging market (EM) debt and US high-yield corporate bonds, an investor has access to an investable universe of almost $6 trillion and can choose from 1,800 issuers.
As a result, strategies that combine these two markets can potentially offer high income generation and enhanced diversification, liquidity and credit quality.
Clarifying the objective function
Capital Group’s Global High Income Opportunities (GHIO) strategy has been managed with the goal of providing, over the long term, a high level of total return, of which a large component is current income.
It seeks to do this over a full market cycle, without increasing the risk that an investor would expect through dedicated allocations to both high-yield and EM bonds.
Diversifying across risk-return profiles
GHIO was developed with the vision that corporate high-yield and EM debt offer similar risk-return profiles, but follow different market cycles – so by investing flexibly across those asset classes, it could offer greater diversification and possibly generate consistent returns.
Given the high level of diversification within the asset classes, however, GHIO’s investment team often finds attractive opportunities in both categories, regardless of geography, asset class, currency, or seniority within the capital structure.
Potential for enhanced income
Both corporate high-yield and EM debt typically offer significantly higher yields than investment-grade sovereign bonds, and, as such, could offer the income component of the higher levels of total return GHIO seeks to provide.
This could prove particularly beneficial in periods of uncertainty for the global economy, potentially providing the strategy with a stable source of return. And, should the macroeconomic environment improve, the potential for capital appreciation could allow GHIO to offer equity-like returns, but with lower volatility due to the income component.
Attention to downside risks
Given that downside risks are a key concern for many investors, GHIO employs a variety of tools to help preserve capital: Issue selection – to help manage identified risks. This includes striving to: offset credit risk by taking positions in more senior debt within the capital structure, protect against interest rate risk by choosing shorter maturity securities, and hedge inflation risk by choosing inflation-linked bonds.
Currency risk in emerging markets – switching to investment-grade dollar-denominated bonds, or maintaining underlying local bond exposure using currency forward contracts to hedge the currency exposure.
Duration reduction – reducing the duration of the portfolio in a rising interest rate environment, i.e. increasing the weighting in shorter duration bonds.
Cash or US Treasuries – the portfolio managers may use cash and near-cash instruments for capital preservation purposes during times of significant decline in global risk appetite.
Seeking a solution in an uncertain environment
The growth of income opportunity funds within the fixed income sector over the past 10 years has been driven by investors seeking yield in a world where income has been low and risk rewarded. With a change in monetary policy across major economies, we believe investors should re-evaluate their income opportunity investments to understand the risk, rewards and managers’ experience in navigating a full credit cycle.
GHIO’s portfolio managers each have more than two decades of experience in managing a broad high income investment strategy and an in-depth understanding of the relationship between the markets in which they invest.
As such, GHIO could provide that high level of income investors seek in a risk-controlled environment.