How to maintain income and manage risk in a low-rate world

Expect rates to remain lower for longer

Markets have been volatile over the past year. Economies broadly speaking (perhaps with the exception of the US), have seen peak growth and are now entering the later stage of the business cycle, characterised by slowing economic growth, decreasing rates as central banks try to stimulate demand, and higher volatility in markets as corporates become more leveraged. This is also a period where strong returns can be generated in risky assets. 

Long-term government bond yields are now at record lows in many countries, including Australia. In October 2019, the Reserve Bank of Australia (RBA) decided to lower the cash rate by 25 basis points to 0.75% to try and boost consumption and stimulate economic growth. The governor of the RBA has stated that this low rate environment should be expected to persist for the longer term.

The chase for yield has many investors taking on more risk

Assuming portfolios are generally efficient, generating higher returns can only be achieved by taking on more risk. As a result, many investors seeking a higher yield are taking on more credit risk in cash and fixed income asset classes. For example, instead of investing in government bonds (backed by sovereign governments and considered to be the most secure type of security), investors may turn to corporate bonds, which are riskier than government bonds but, in turn, pay a higher rate of interest. They may also look at different parts of the capital structure of those corporates, moving out of the senior secured part of the capital stack and investing in more subordinated tiers, such as hybrids or even the equity itself – all in an effort to maintain the income part of the portfolio.

This can be problematic because increasing the level of risk in the defensive part of the portfolio can lead to increased correlation with growth assets. Fixed income and cash is also supposed to provide a defensive characteristic – without this balancing factor the portfolio will be more exposed to market corrections, and thus experience greater drawdowns.

Diversification is key to maintaining income

In a low-yield world, just increasing credit risk in fixed income assets is not the safest way to maintain portfolio income. At Perpetual Private, we seek to maintain income by accessing different types of ‘alternative’ assets that can generate returns in a more diversified way. For example, in our Income Opportunities Fund, we look beyond just traded markets and delve deeper into markets such as private credit and private mortgages.

We also explore assets like infrastructure debt and other alternative sources of income which can be hard for many investors to access. While these opportunities can present other risks to investors, such as illiquidity or inefficiency, they can be managed by sizing the allocations to these assets and managers appropriately across a broadly diversified portfolio.

Diversification is key to maintaining income

Alternative assets can play an important role in client portfolios as they provide an opportunity to maintain returns, but also enhance portfolio diversification as opposed to concentrating the risks in portfolios. The award-winning* Income Opportunities Fund is our income alternatives asset program for clients.

The Fund was designed specifically for a large part of our client-base that are heavily reliant on income, such as retirees, philanthropists or charitable trusts. It aims to deliver a higher return than cash (cash plus 1% net of all fees) but do it in a way that’s much more diversified than a traditional approach.