Yield us not into temptation

Income investing part II

In my previous post I outlined the possible benefits of using multiple asset classes to achieve a more stable and attractive level of yield from an income-focused portfolio. In this post I take aim at targeting a fixed level of yield, showing that this objective could mean you miss the big picture.

 

It’s nice to think that as an investor you could pick a yield number that suited your income needs and then go out into the market and build a portfolio to meet that. Let’s say that number was 5%. As highlighted in my previous post, that would have been a modest target in years gone by, given high levels of 'natural' income. However, as a result of ongoing changes in markets, meeting such an arbitrary number from natural income would mean the composition of the fund would have changed dramatically over time, incurred high trading costs and, of course, a changing risk profile in terms of volatility, geographic and asset class exposures.

 

“Increasing yield does not necessarily mean increasing risk but targeting yield means that you have less control of that risk”

 

For example, to achieve a 5% yield target 15 years ago, a portfolio could have theoretically consisted of 95% government bonds and investment grade corporate bonds. Fast forward 10 years and the lowest risk portfolio that could potentially have had a 5% yield target would have had just under half of the portfolio in lower risk government and investment grade corporate bonds, with the other half in riskier high yield and emerging market debt. Onwards to 2017, with yields on all assets having fallen further, and the portfolio would now need over 75% allocated to the riskier bonds, and just under a quarter in government bonds.  

 

 

This illustrative example highlights how yield targeting could present challenges should you wish to keep portfolio risks somewhat stable. A focus on risk can remain central even when an investor has an additional income objective. It is also important to note that the relationship between yield and risk is a complex one. Increasing yield does not necessarily mean increasing risk but targeting yield means that you have less control of that risk. You cannot target yield and risk at the same time; therefore by targeting yield, it means by definition that risk becomes variable.

 

 

Tweaking the allocations of a portfolio towards higher-yielding assets like real estate and emerging market debt can work well to boost income, but the risks should be balanced out elsewhere, for example by reducing exposure to traditional equity investments. Monitoring the broader risks investors are primarily concerned with, such as expected losses in a downturn and the stability of cashflows, is crucial.

 

While creating a bias towards income within portfolios may be desirable, we believe that you should not lose sight of the bigger picture, the risks to the capital and the total return potential of the investments.

 
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