Today’s investors may feel inundated with information on how their portfolios can be derailed – including a steady drumbeat of geopolitical crises. In our view, many of these risks will ebb and flow over time. Besides, they may either happen or not. So it can be difficult to hedge or invest around these risks.
A less discussed danger is that these concerns could prevent investors from pursuing their long-term goals or deter them from taking sufficient risk in their portfolios. Some investors could even be ignoring serious risks that are less tangible, like climate change or inflation, but that can nevertheless be incorporated into an investment strategy.
Given the relatively low levels of inflation in many economies, it’s understandable why it may not be at the forefront of investors’ minds. However, even small amounts of inflation can significantly erode purchasing power over time through the power of compounding.
A 2 percent annual inflation rate can reduce the value of an asset by nearly 20 percent in just 10 years. This is a clear example of why taking insufficient risk in low-return investments can put investors’ goals at risk.
While official inflation measurements like the consumer price index (CPI) may be low, they also have inherent limitations and fail to capture the real-world experience of many consumers.
In many parts of the world, healthcare expenses, education costs and real estate are climbing faster than the official 2 percent inflation target of most major central banks.
Moreover, many governments are actively trying to push inflation even higher than 2 percent to help them pay down their debts. Federal Reserve governors recently suggested that they might let inflation in the United States “run hot”.
To combat inflation, investors can use several approaches. Capital appreciation from equities and other real assets can be a good inflation-fighting tool, but those returns could take time to materialize. These assets can also be subject to rapid drawdowns similar to what the markets experienced in the fourth quarter of 2018.
A steady income stream, on the other hand, can be more tangible, helping to stabilize returns and make them more predictable. Moreover, the historically lower risk profile associated with income-generating investments might help reduce portfolio volatility in times of market and economic stress.
So where can investors hunt for income today? One option is government bonds – sometimes called sovereign debt – which are among the “safest” kind of income-generating securities available. But recent data from Bloomberg showed nearly US$10 trillion in negative-yielding bonds on the market, much of which is sovereign debt that we believe is unlikely to deliver a positive return.
Fortunately, there are other types of securities – e.g., corporate bonds and equities – that may be able to generate higher levels of income in exchange for certain additional risks, and each one provides access to different parts of the corporate capital structure.
For example, the same company could theoretically issue corporate bonds, convertibles, stocks and high-yield bonds. The ability to choose where to invest along the capital structure lets investors choose which risks they are prepared to carry – while helping them target the desired level of income potential.
Although there are many ways to generate income, there is no “one-size-fits-all” solution for any investment strategy. It is impossible to predict which assets will outperform at any given time. Investors should diversify across asset classes to help capture opportunities. This is where an active and global approach can help, since active managers can dynamically research and analyze these complex issues.
Similarly, just as all investing invites some degree of risk, there are certain risks that can affect income-generating securities, including:
• Interest-rate risk: when rates rise, a bond’s value generally falls.
• Credit risk: issuers could default on paying income or repaying principal.
• Inflation risk: it reduces purchasing power over time.
• Liquidity risk: it could be hard to find a buyer or seller at the right time.
With lower beta returns (what the broad market provides) likely for the next decade, we believe that investors should pursue alpha – or returns in excess of the market. Investors who successfully hunt for income can help protect their portfolios’ purchasing power, seek acceptable returns and aim to reduce overall risk levels during uncertain times.
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