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Guide To Seeking Income In A Rising Rate World

The search for better yields is constant

This article was contributed to us by Stephen Dover, Chief Market Strategist and Head of Franklin Templeton Institute and Christy Tan, Investment Strategist, Franklin Templeton Institute

The search for income has become more complicated as inflation in the U.S. soars to four-decade highs while the global economy wrestles with the continued supply and demand imbalances from the pandemic and war in Ukraine. In Asia, headline inflation has risen to multi-year highs for some economies, triggering policy tightening in South Korea, India, Malaysia and the Philippines. In Singapore, the Monetary Authority of Singapore took a further calibrated step to tighten monetary policy in an off-cycle move in July and revised the headline inflation forecast to 5.0% to 6.0% for 2022  from 4.5% to 5.5%.

Consequently, broad monetary policy tightening is raising concerns about slowing global economic growth In this uncertain environment, income is an effective tool to manage the volatility of an investment by providing steady cash flow as the principal value is fluctuating. Income opportunities exist for investors willing to broaden the potential sources of yield.

While Rising Bond Yields Present Opportunities, Volatility May Remain Elevated

Unsurprisingly, the pivot to a hawkish policy tack by major central banks has adversely impacted fixed income markets. Bond prices have declined, and nominal yields have moved sharply higher.

While existing bondholders are nursing substantial capital losses, the sharp sell-off in bonds has opened an interesting opportunity to invest in various fixed income asset classes at meaningfully higher starting yields compared to recent history. Nevertheless, high inflation invariably translates to lower real yield (nominal yield minus actual inflation), eroding the purchasing power of fixed income streams over time.

As it stands, the International Monetary Fund (IMF) has pencilled in a world consumer price inflation rate of 7.4% in 2022. This implies a large share of global bonds may still be delivering negative real yields. Similarly, long-term real yields on developed market government bonds remain in negative territory even as nominal yields have risen due to higher inflation expectations.

Also, while better value has emerged in certain segments of the fixed income market, valuations could get more attractive as monetary policy and geopolitical dynamics evolve, and as investors demand higher compensation for rising prices. Higher volatility in an otherwise historically steady market may signal heightened uncertainty about the economic and policy risks that lie ahead. These fluid developments suggest volatility could stay high for some time. Inflation and Fed fears are partly responsible, but so too is the large price impact associated with rising bond yields from very low starting levels. The inversion in the Singapore government bond yield curves up to 15-year bonds clearly reflects some lingering volatility amid broad moves higher compared with the start of the year.

Cast A Wider Net For Income

These challenges underscore the importance of casting a wider net for income generating assets. Income seekers may have to accept reasonable levels of credit and equity risks to enhance yield in their portfolios. Diversification of income sources is especially important as market volatility remains elevated.

#1 Dividend Stocks And Hybrids Will Be Key Sources Of Yield

Accepting some equity risk in the form of dividend paying stocks may be necessary to enhance portfolio yield. Against a more uncertain economic backdrop, investors may continue to lean on high quality dividend plays such as stocks of companies with robust free cash flows and long track records of growing dividends over time. These companies tend to have wider competitive moats and stronger pricing power and should be able to preserve profit margins as cost pressures increase.

In addition, companies with cash flows that tend to reset higher in the face of enduring inflation such as listed infrastructure and real estate, may be useful as both a source of income and inflation hedge.

Even among growth-style stocks that may not necessarily pay out dividends, hybrid instruments like equity-linked notes can help manufacture income where it may not have previously existed. Such instruments can deliver enhanced yield while also capturing some of the potential capital upside of an underlying stock.

Adopting a multi-asset approach by including healthy dividend growers and hybrids in the mix helps widen the opportunity set for income generation and inflation-adjusted yield enhancement.

#2 Floating Rate Notes And High Yield Bonds Can Provide Shelter From Rising Interest Rates

If inflation remains elevated and central banks respond with higher-than-expected rate increases, investors should consider using short-duration instruments to mitigate interest rate risks.

High yield bonds and floating rate notes (or leveraged loans) are appealing candidates in this environment given their higher nominal yields, low duration and relatively lower volatility. These instruments have better quality and stronger fundamentals than in the past, and unless economic growth falls dramatically, there is likely to be a low rate of defaults.

Understanding individual company default risks are important in order to maximize returns and minimise risk, especially in the leveraged loans space where the proportion of covenant-lite loans has increased over the years.

#3 Private Market Opportunities

Increasingly, investors are also turning to private markets in search of yield. Private real estate – commercial real estate (multi-family, industrial, office, retail, life sciences, and warehousing) in particular – have become progressively more accessible to retail investors as an instrument for portfolio diversification and income generation.

It is a compelling asset class insofar as it exhibits lower volatility relative to stocks, higher yields relative to traditional fixed income assets and lower correlation to returns from equities and bonds.

Given that real estate leases tend to have contractual rent increases that are linked directly to annual inflation rates, the asset class has historically acted as a robust hedge against inflation.

#4 High-Quality Bonds Are Still Relevant For Portfolios

In the face of higher economic and policy risks, the quest for yield should not come at the expense of risk management. Higher market volatility is to be expected as countries continue to deal with higher inflation, supply chain disruptions, tighter financial market conditions and the ramifications of geopolitical shocks.

We believe it is still prudent to maintain some defensive posture in fixed income and allocate into high quality bonds or duration plays that can act as a bulwark against deteriorating market conditions, while still capturing some yield. As high-quality fixed income assets tend to either weakly correlate or negatively correlate with risk assets, they are especially useful as a diversification tool in investment portfolios.

Stay Active

In our view, diversification of income sources, judicious credit and stock selection and active management should be top of mind as investors expand the search for yield amid choppier waters.

We also believe active management will be key to uncovering opportunities and unlocking value in a wide array of regional markets and asset classes as well as navigating a more volatile market environment ahead amid flaring inflation, economic and policy concerns.

This article was contributed to us by Franklin Templeton Institute.

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