Hitchhikers' guide to yield seeking

• New interest rate and inflationary regime presents a wide array of attractive yield opportunities across asset classes and instruments.
• No one size fits all – investors need to factor in diversification, tolerance for volatility and investment horizon.
• Risk management is crucial as volatile markets can impact returns substantially, even for investments traditionally deemed to be safe.

Source: AFP

As inflationary forces and interest expectations rise, the need for yield remains clear and present. However, this quest for yield is now made in unchartered territory, in a new galaxy of higher and potentially more volatile interest rates than experienced in the past decade. This serves as a handy guide for yield seekers, by highlighting key considerations when picking income-generating investments for investment portfolios.

What has changed?

The new era of higher interest rates - caused by inflation, pandemic and war - is set to last for the rest of decade.

This is transforming the fixed income universe by making high-quality Developed Markets (DM) and Investment Grade (IG) bonds attractive again after the 2008 financial crisis led to a decade of very low yields and investors focusing only on Emerging Markets (EM) and High Yield (HY) bonds. 

In contrast, the next decade will be characterized by more persistent inflationary forces combining higher goods prices, wages and energy prices. Geopolitical tensions between US and China have resulted in increased friction of global supply chains which are in turn costlier. Renewed challenges to what used to be a seamless flow of physical and human capital, as well as capital goods and raw materials all add up to higher costs and prices. In an inflationary environment, investors now need to consider positive real yields (which are inflation-adjusted).

Central bank policies of US, Europe, Japan and China will diverge in the coming years as these major economies balance inflation and economic growth at varying stages of the economic cycle. These yield differentials make geographical diversification within the fixed income portfolio relevant over this period.

Investing in yield instruments is intertwined with interest rates – both expected and realized due to the inverse relationship between bond prices and interest rates. Hence, both duration (i.e. interest rate sensitivity) as well as credit spreads need to be considered by bond investors.

The spectrum of income instruments relies on a range of variables that include yield generating potential, certainty of yield, tenors, duration, credit quality and liquidity. These present tradeoffs between expected return and risks that need to be quantified and calibrated according to one’s return expectation, risk tolerance and investment horizon. Hence, within the context of a well-diversified multi-asset portfolio, the yield portfolio needs to be sufficiently diversified to balance these dynamics, particularly in a volatile interest rate environment.

Source: AFP

Framework for incorporating yield into portfolio construction

Portfolio construction is an ongoing and multi-faceted journey, one that optimises risks and returns across a range of investment instruments by incorporating critical investor preferences and perspectives. This framework is valid even as investors focus on generating healthy and resilient levels of yield from their portfolios.

Asset allocation decisions are often made in accordance with investors’ desired level of diversification. While yield-seekers might naturally gravitate towards bonds, it is important to consider whether the addition of such securities provides diversification benefits or inadvertently contributes to concentration risk. 

The traditional 60% in stocks, 40% in bonds portfolio enjoys a certain level of diversification, given the negative equity-bond correlations since the early-2000s. However, it is also important to consider what type of bonds are in the portfolio. For instance, HY bonds and equities tend to exhibit similar return profiles over a full market cycle, and confers minimal diversification benefit to a stock-heavy portfolio. On the other hand, the introduction of HY bonds in a large IG fixed income portfolio could be beneficial from a diversification perspective, given the lower correlation between the two sub-asset classes.

Diversification can also take place across maturities via the process of laddering. This involves including fixed income securities of differing maturities ranging from short-term to long-term bonds. This is a helpful strategy in mitigating interest rate risk and reinvestment risk. Should short-term bonds mature at a time when interest rates are elevated, the challenging bond price environment can make reinvestment into longer-dated paper an attractive proposition.

The risk appetite and tolerance for volatility are also important factors to consider in portfolio construction. Traditional yield plays like bonds are likely to deliver less volatility and more stable income than equities, but conversely are not able to participate in the longer-term capital appreciation.

Investment time horizons vary across investors, and this needs to be matched with instruments that provide the appropriate liquidity profile. Some sources of yield could require investors to commit to remaining invested for a considerable period of time. Using private credit as an example, the higher yielding but illiquid opportunities across a range of risk/return profiles might not be suitable for all investor types.

Specific to fixed income, taking a view on interest rate movements is essential in managing duration. Should investors expect interest rates to rise, bonds with shorter duration would be more desirable as the value of such bonds will fall less than comparable bonds with longer durations. Being nimble in managing duration can help build portfolio outperformance while managing risk at the same time. The shape of the yield curve i.e. the yield differential between long and short term instruments (e.g. 10Y vs 2Y treasuries) is also a consideration in managing duration.