Building income portfolios in today's market environment is neither simple nor straightforward. Using solely traditional fixed income instruments can be a challenging quest, as bond returns are likely to remain low by historical standards for an extended period. A well-constructed income portfolio should use a broadly diversified approach.
In the past, income-focused portfolios invested primarily in traditional core bonds such as those issued by the federal government. But in order to achieve attractive yields in today's low-rate environment, one must expand the investable universe across the entire fixed income spectrum and make use of some asset classes that are often considered exotic or satellite investments.
Within the core fixed income asset class, investors should use bonds with varying maturities. Short-term bonds could be relatively sound investments when interest rates increase, since the negative price impact from rising rates will be small due to their low durations. At the other end of the maturity spectrum, long-term bonds offer the best hedge for long-term liabilities and therefore deserve consideration for inclusion in an income portfolio, especially for investors who are in retirement.
Other yield-enhancing fixed-income asset classes such as corporate, high-yield and emerging markets bonds as well as floating-rate notes are also important additions to income portfolios. These asset classes not only provide attractive yields, but each plays a specific role in the portfolio due to the way they respond to changes in interest rates and how they interact with other investments.
For example, all bond prices go down when interest rate rises; however, corporate and high-yield bonds are likely to lose less than government bonds in a rising rate environment since they are less sensitive to interest rate changes. Therefore, making them part of an income portfolio not only provides a boost in yield but also offers protection against interest-rate risk.
Emerging market debt securities offer diversification benefits in addition to potential for higher total returns. Floating-rate notes offer investors an opportunity to earn higher coupon rates, and due to their extremely low durations (effectively zero) they don't lose value when interest rate rises. However, they may not be suitable for everyone, especially risk-averse investors, because of their below-investment-grade quality and hence higher credit risk.
Additional sources of yield could come from alternative asset classes such as real estate income trust (REITs). REITs are high-yielding securities that also provide liquidity and serve as diversifiers against market risk (for equities) and credit risk (for bonds).
Equities play a crucial role in income portfolios, but income-focused investors should favour stocks that pay regular and rising dividends. Unlike bonds that pay fixed coupons, dividend-paying common stocks provide the opportunity for capital appreciation and a rising income stream as dividends grow with earnings. Furthermore, stocks exhibit a positive relationship with interest rates, which means they tend to perform well during periods of rising interest rates.
Once you have established a list of the major building block asset classes, the next step involves figuring out the weightings for each asset class. Asset allocation for income portfolios is determined based on total return, risk, correlation and yield of the eligible asset classes. When designing an income-focused portfolio it is important to find the right balance between maximizing yields and achieving an acceptable total return while minimizing long-term risk to capital.
Total return is comprised of both income return and price return, but there is a trade-off between total return and yield. In order words one needs to sacrifice some total return (or accept a higher level of risk) in order to obtain a higher yield (as illustrated in the chart below).
For this reason when constructing high-income portfolios, Morningstar Investment Management (the investment management division of Morningstar) uses enhanced income optimization in setting the target asset allocation. Enhanced income optimization allows us to maximize return for each level of risk and minimum required yield. Our research shows the optimal income portfolio allocates 20% to equity, 20% to 30% to alternatives such as REITs, private equity and infrastructures, and the remaining 50% to 60% goes to fixed income.
The last step is security selection, where investors need to choose the underlying investment vehicles (i.e. mutual funds or ETFs) to fill each asset class buckets. Comprehensive qualitative and quantitative analysis using both holdings-based and return-based style analysis should be conducted at this stage. The goal is to get the right mix of various investments while still maintaining the desired target income and risk profile. Each investment has different attributes and carries different risks (i.e. market, credit and liquidity risk), and they should not be selected in insolation but rather based on their contribution to income and risk level, and ultimately how well they fit together in the overall income portfolio.
Despite interest rates being at historic lows, investors can still meet their income needs by using a well-diversified multi-asset-class, multi-strategy approach that considers factors such as capital preservation, future growth potential, diversification, economic growth and interest rate movements in building an income portfolio. This means they need to use a broader range of investments and a thorough understanding of how each investments contributes to the portfolio's income, return and risk profiles. While income generation is the main goal, the performance of the overall total portfolio is what really matters.
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