One of the challenges for income investors is that while government bond yields have risen markedly over the past year, for most clients they remain below the prevailing rate of inflation, and so the income from a government bond may not be capable of maintaining the spending power of a client reliant on the income.
The intuitive course of action is to have an allocation that involves taking more credit risk as the yields on such bonds are higher, and, in many cases, offer yields that are greater than the prevailing level of inflation.
But for all that the income is higher, so the risks are higher, as they involve exposure to corporate entities at a time of deteriorating economic data.
In more normal market times, the deteriorating economic conditions would be leading to a drop in inflation, potentially making the yields on the lower-risk government bonds sufficient.
But if we have the sort of stagflationary environment that some parts of fixed income markets are presently pricing, then economic conditions could deteriorate, reducing the appeal of credit assets, but also keeping those invested in most parts of the sovereign debt market in a position whereby, if income is their focus, they are losing spending power.
Thomas Gehlen, senior market strategist at SG Kleinwort Hambros, says that in the current economic climate, the extra yield offered by high-yield bonds does not justify the extra risk, and adds that investors would be better served, if they wish to achieve a higher income, to own income-paying equities or assets such as infrastructure.
Robert Alster, chief investment officer at Close Brothers Asset Management, says that, "in the Close Select Fixed Income bond fund, we operate with a cautious approach: 16 per cent in government bonds; 67 per cent in investment-grade bonds; and just 13 per cent in high-yield bonds (and only in the safest “BB” part of the high-yield universe).
"This diversification allows us to boost the overall yield of the fund to 8 per cent, while maintaining a very strong average rating of the fund of BBB+. Bond funds now offer a genuine income for investors, for the first time in a generation.”
He adds: “If income is a priority for an investor, then corporate bonds remain a fundamental part of a portfolio. As government bond yields have increased significantly over the past two years, so too have corporate bond yields.
"Indeed, sterling investment-grade bonds offer yields of [around] 6.2 per cent in October 2023, while riskier sterling high-yield bonds offer yields of [around] 10.4 per cent.
"Given the general macro uncertainty, coupled with the relatively attractive ‘all in’ yields offered by government bonds, we believe that a portfolio should be well-diversified across government bonds and investment-grade bonds, with a much smaller and very selective allocation to ‘best-in-class’ high-yield bonds."
A representative of PIMCO says its base case macro outlook and projections anticipate core inflation will trend lower but remain above central bank targets for a while in some developed economies, including the US and Europe, potentially resulting in a re-acceleration in core inflation over the next few months.
