Rising risks in the hunt for investment income
Most charities need all the income they can get and high income generation is often prominent on the list of investment requirements. However, against a backdrop of sustained minimal interest rates, investments generally offer much lower income returns than in the past. Charities must, therefore, either accept the drop in income or seek alternative and potentially riskier investments to satisfy the same levels of spending.
Various yield enhancing strategies have been used by charities since 2008, but at such a late stage in the interest rate cycle, a continued focus on income leaves portfolios in significant danger of capital deterioration. A total return approach to income generation can mitigate some of these risks, resulting in more reliable performance and a portfolio fit to last for generations.
There are ways to boost income, but charities should pursue them with caution . Over the past five years, three yield enhancing investment strategies have taken centre stage: extending the duration of bond portfolios, tilting bond holdings towards high yield, and shifting equity holdings towards dividend paying stocks.
Long term bonds
The first move charity investors often make when seeking to increase their portfolio’s yield is to raise the allocation to investment grade bonds of a longer maturity (and consequently to those with a higher duration, or sensitivity to changes in interest rates). To illustrate, although money markets yield between 0.5% and 1%, 5-year gilts yield 1.7% (duration of 4.7 years) and 10-year gilts yield 2.4% (duration of 8.8 years). It is therefore easy to see why charity investors may try to increase their yields by investing in longer term securities.
However, there are two main risks associated with this strategy. Although long term bonds generally pay higher yields than short term bonds, for a given rise in interest rates, they tend to fall much more sharply in price. For example, when the Federal Reserve surprised markets with an unanticipated increase in interest rates in 1994, it resulted in a stampede out of long term bonds and significant losses for investors.
Secondly, current yields are so low that they provide little cushion for rising interest rates, representing a magnified risk for charity investors at today’s levels. The current yield may not offset even a marginal decline in prices due to rising interest rates. Consequently, duration extension might not be such a suitable strategy for charities where principal security is important.
High yield bonds
Many charity investors also turn to higher yielding bonds, which are often exposed to significant credit risk. The bonds that are sold by companies with fragile balance sheets and a higher probability of default have become one of the most popular securities among global investors in search of income. Lured by higher returns and a low current default rate, investors have queued to buy record amounts of high yield bonds (“junk bonds”), which in turn have been sold at ever more expensive levels and often with looser protections for the lenders than equivalent issues in previous years.
There are three primary concerns. First, replacing existing fixed income with higher yield bonds tends to increase volatility by some margin, resulting in a closer correlation to equity markets. Despite a favourable short term record, since the beginning of 1999 high yield bonds have witnessed an annualised price standard deviation of 9.8% versus 6.6% for their investment grade equivalents. In addition, they have seen a maximum drawdown from peak to trough of -33.3%, versus -15.0% for the investment grade market. Where investment grade bonds can provide an important element of diversification at times of market stress, their high yield cousins fall short.
Secondly, yields on high yield bonds have reached levels that no longer compensate investors for the higher risks associated with them. The average high yield bond currently yields about 5.3%, only marginally higher than the all-time low. During the financial crisis, yields reached upwards of 20%; since bond prices and yields move in opposite directions, investing in high yield bonds now is very likely to result in capital depreciation at some point in the future.
Finally, despite anaemic global economic growth, the default rate on high yield bonds is close to an all-time low of 2.1%. Companies around the developed world have taken a golden opportunity to issue bonds at record low interest rates, and this has resulted in a plethora of new bond issues of lower quality than previously. Combined with the prospect of rising interest rates, there is clearly capacity for default rates to rise towards their long term average of roughly 5%, spelling trouble for investors in the asset class.
Dividend paying stocks
Dividend investing is more popular than ever as towering equity valuations, amid sluggish economic growth, cap the potential for further share price gains while low bond yields limit the attraction of fixed income assets.
However, portfolios of dividend focused equities commonly display a significant bias towards value stocks (i.e. stocks tending to trade at a lower price than expected relative to their fundamentals); charities are likely to suffer by opening themselves only to businesses which have low (or no) growth potential. The result is a systematic lack of exposure to important sectors that will help their portfolio to grow, such as technology and financial stocks, and an over-reliance on those which won’t, namely consumer staples.
Another closely related problem is that following the dividend cuts of 2009 and 2010, the number of companies in the UK which pay dividends has become increasingly concentrated. The components of the FTSE 100 Index produce around 90% of the UK’s total dividends. Relying on dividend payers therefore makes it difficult for charities to diversify their portfolios as much as they should.
Inherent concentration also leaves charity investors open to a more serious problem. If an investor buys a high dividend stock and the dividend is cut, he will suffer the double loss of income and a falling stock price. For example, in early 2010 BP was the biggest dividend payer in the UK. The Gulf of Mexico disaster saw the oil giant’s profits fall dramatically and £5.4bn in dividends were cancelled. Investors were forced to take a dramatic hit to their income levels while simultaneously stomaching a crash in the capital value of their stock; the equity fell by almost 50% in just over two months.
Finally, it is important to note that the significant focus on dividend stocks since 2002 has driven relative valuations (based on price/earnings) well above their average. Appetite has been particularly abundant in 2014. To illustrate, for the year to date the S&P 500 Index posted a total return of 9.9% and it has been the highest yielding names which have driven these returns. Stocks yielding more than 6% have risen 28.9%, whereas those yielding 3% or under have risen by only 8.2%. Higher profits are needed to justify current equity valuations but given the questionable outlook for the global economy, this is far from certain.
A total return approach
As we have seen, some charities find that their need for a certain level of income has prevented them from spreading their investments over a sufficiently diverse range of asset classes. In some cases, charities may have found that current beneficiaries were at a disadvantage at times when, in the prevailing investment climate, income yields were low, even though capital growth remained healthy.
It is perhaps with this scenario in mind that the Charity Commission introduced the Trusts (Capital and Income) Act 2013, to allow all charities, including those which are permanently endowed, to take a total return approach to investing without seeking prior approval. It does not automatically force investment into low yielding assets, instead providing trustees with the flexibility to invest in them if they so wish.
A total return approach allows charities to invest more widely, and increased diversification can be a powerful strategy in managing volatility. In an environment where yields on some of the safest assets such as cash and fixed income have been supressed to historic lows, it is important not to disregard asset classes which deliver most of their return in the form of capital growth, such as many alternative asset classes (commodities, hedge funds) and index-linked gilts. Crucially, as the market sell-off in the second half of 2011 amply illustrated, such securities can provide valuable stability when equities (including dividend paying stocks) and high yield bonds are plummeting.
Whilst aligning the withdrawal rate for a charity's funding purposes with total portfolio yield makes sense on paper, in practice a charity’s investment returns can suffer as a strict focus on the bottom line quarterly dividend often results in reduced long term capital growth. On the other hand, total return enables foundations to spend more on grants than would otherwise be possible. For example, The Nuffield Foundation has used a total return approach since the 1980s and spends 5% of it a year when its "actual income" is only 2%.
However, this isn’t to say that total return investors favour freely tapping capital until it’s gone. Rather, the goal of a total return strategy is to grow the overall money by maintaining a diversified pool of investments – some income producing, some which will appreciate in price and some which will do both. Income generation should be a goal for every investor; it is, after all, one of two key components of the total return equation. Importantly, blending the two approaches allows charity investors to benefit from the stability that income producing securities bring without sacrificing diversification or chasing securities which, in hindsight, turn out to be yield traps (because the dividends are cut).
A total return approach is not just about spending resources which under the standard rules would be capital gains. It can also be about retaining resources as unapplied total return for the protection of the interests of future beneficiaries. It may seem counter-intuitive, but in this way, investing for total return can result in a steadier withdrawal programme than if relying solely on income.Done in the right way, total return can achieve higher returns with lower risk, providing charities with the income they need today and, more importantly, the income required for future activity.
How it works
In practical terms, the following would happen:
- The charity would select a sustainable withdrawal rate, say, 4% per annum.
- It would make a top level allocation of 40% to high quality bonds and the balance to a portfolio of diversified global equities.
- Cash for distributions can be generated as the situation requires, harvesting gains from equities in good times and bonds during equities’ bad times.
- Rebalancing along the way will enhance performance over the long term by enforcing a discipline of selling high and buying low.