Global Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

July 18, 2016

Chris Haverland, CFA®, Asset Allocation Strategist

Time to Diversify Your Income Streams

  • Modest economic growth in the developed world and highly accommodative central-bank policies likely will suppress government bond yields for an extended period.
  • Sourcing yield through multiple asset classes may help mitigate return volatility while providing adequate income that outpaces inflation.

What it may mean for investors

  • In this low-rate environment, we recommend diversifying income streams by investing in income-producing assets across fixed income, equities and real assets.

In this environment of slower economic growth and record low interest rates, it can be very difficult for income investors to generate a desirable level of cash flow from their investment portfolios. Modest economic growth in the developed world and highly accommodative central-bank policies likely will suppress government-bond yields for an extended period and hamper an investor’s ability to source enough income to outpace inflation. At the same time, perceived “safe” haven fixed-income investments, such as developed sovereign debt, face increasing levels of credit and interest-rate risk. Rising credit risks have come from higher developed-country debt burdens, while interest-rate risk continues to climb as yields approach and go below zero in many nations.

Chart 1: Asset Class Yields and Tactical RecommendationsChart 1: Asset Class Yields and Tactical RecommendationsSource: Bloomberg, 7/13/2016. High Yield Bonds: Barclays U.S. Corporate High-Yield Bond Index; Emerging Market Bonds: JPM EMBI Global Index; Global REITs: FTSE EPRA/NAREIT Developed Index; Developed Market ex U.S. Stocks: MSCI EAFE Index; Emerging Market Stocks: MSCI Emerging Markets Index; Large Cap Stocks: S&P 500 Index; U.S. Investment Grade Bonds: Barclays U.S. Aggregate Bond Index; Developed Market ex U.S. Bonds: JP Morgan Global Ex United States Index (JPM GBI Global Ex-US); Cash Alternatives/Treasury Bills: Barclays U.S. Treasury Bills (1-3M) Index

Although bonds traditionally have provided a major source of income for investors, there are a variety of options available when constructing an income-generating portfolio. This would include diversifying income streams within and outside of the fixed-income portion of your portfolio. Sourcing yield through multiple asset classes may help mitigate return volatility while providing adequate income that outpaces inflation. Some higher yielding, albeit riskier, alternatives can be found in the fixed income, equities and real assets categories (see Chart 1).

Within fixed income, including corporate bonds (both investment grade and below investment grade) may provide diversification benefits and enhance overall portfolio yield. We see value in high-quality corporate debt and recommend an overweight allocation. Investors are currently being compensated for taking credit risk, and we do not see a high probability of a recession in the near term. Although we have a bias toward higher quality in the current market, we believe investors should maintain a strategic allocation to high-yield bonds. Additionally, municipal bonds can help diversify income streams while providing tax benefits.

International bonds (both in developed and emerging markets) can offer another source of income; however, today’s low-rate environment has kept us underweight in developed-market bonds outside the U.S. According to Fitch Ratings, as of June 27, there was $11.7 trillion of sovereign debt with negative yields.1 This phenomenon is largely due to aggressive monetary policy easing and an investor flight to quality. Emerging-market fixed income can provide attractive yields, but similar to high-yield bonds, credit risk must be weighed (we are currently evenweight on this asset class). Currency movements are another possible risk. We recommend dollar-denominated emerging-market bonds, which eliminate the currency risk. Regarding international developed-market bonds, investors whose savings are in dollars but who do not hedge away the currency risk could see dollar appreciation detract from their returns. We are neutral on the U.S. dollar into year-end, meaning that we do not expect broad and sustained dollar appreciation or depreciation in the balance of 2016. However, even temporary dollar appreciation could generate losses for bond positions denominated in local currencies.

Equities also can be an important source of income in investment portfolios—with many stocks offering dividend yields that are higher than U.S. Treasury yields. Our lone overweight in the equities asset group is in U.S. large cap, which is based on the S&P 500 Index and has a dividend yield of 2.2 percent (compared to approximately 1.5 percent for the 10-year U.S. Treasury note). Certain defensive sectors, such as Utilities and Telecom Services, also can provide relatively high dividend yields; however, we are underweight these sectors due to valuation concerns. International equities currently boast relatively high dividend yields—with the MSCI EAFE Index yielding 3.5 percent and the MSCI Emerging Markets Index yielding 2.7 percent. We recommend diversifying assets globally, and at this time, we have an evenweight rating on developed-market equities outside the U.S. and an underweight rating on emerging-market equities.

There are several opportunities for income in the real assets space as well. Public and private real estate may offer attractive income streams relative to bonds and equities. With special tax status from the Internal Revenue Service, U.S. real estate investment trusts (REITs) are required to distribute at least 90 percent of their taxable income to investors, which generally allows for higher dividend yields relative to the broader equity market. We currently have an overweight rating on public real estate with a bias toward U.S. REITs. Master limited partnerships (MLPs) are another highly volatile income option. The structure of MLPs is suitable for established and consistent income-producing assets of energy companies and allows for the distribution of the highest level of income to limited partner unitholders.2 When constructing an income-generating portfolio, we believe that it is important to consider a variety of diversified income sources. Although bonds are a critical portfolio component for income-sensitive investors, they are not the only income source available to investors. There are numerous options in fixed income, equities and real assets when it comes to diversifying your investment-income streams. These strategies can potentially provide higher yields; however, without proper diversification, they can add an increased level of risk to a portfolio. Their appropriateness for an investor’s specific circumstances needs to be carefully considered and based on income and growth needs along with risk tolerance.

1 Fitch Ratings, June 29, 2016.
2 MLPs can be highly volatile and should not be considered an alternative to a well-diversified bond portfolio. Rather, these investments should represent a small portion of a portfolio’s income-generating allocation. Historically, yields have been attractive in this space, but the distributions are not guaranteed and there are a limited number of investment vehicles, which can lead to capacity concerns. Because of the unique tax considerations and risk factors associated with MLPs, investors should consult their tax advisors to be sure MLPs are appropriate for their tax situations.

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security.

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Dividends are not guaranteed, and are subject to change or elimination.

Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

While stocks generally have a greater potential return than government bonds and treasury bills, they involve a higher degree of risk. Government bonds and treasury bills, unlike stocks, are guaranteed as to payment of principal and interest by the U.S. Government if held to maturity.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer.

Currency hedging is a technique used to seek to reduce the risk arising from the change in price of one currency against another. The use of hedging to manage currency exchange rate movements may not be successful and could produce disproportionate gains or losses in a portfolio and may increase volatility and costs.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Definitions

An index is unmanaged and not available for direct investment.

Barclays U.S. Aggregate Bond Index is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.

Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB= or below. Included issues must have at least one year until final maturity.

Barclays U.S. Treasury Bills (1-3M) Index is representative of money markets.

FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

JP Morgan EMBI Global Index is a U.S. dollar-denominated, investible, market cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt. While products in the asset class have become more diverse, focusing on both local currency and corporate issuance, there is currently no widely accepted aggregate index reflecting the broader opportunity set available, although the asset class is evolving. By using the same index provider as the one used in the developed-market bonds asset class, there is consistent categorization of countries among developed international bonds (ex. U.S.) and emerging market bonds.

JP Morgan Global Ex United States Index (JPM GBI Global Ex-US) is a total return, market capitalization weighted index, rebalanced monthly, consisting of the following countries: Australia, Germany, Spain, Belgium, Italy, Sweden, Canada, Japan, United Kingdom, Denmark, Netherlands, and France.

MSCI EAFE Index (Europe, Australasia, Far East) Index (MSCI EAFE GR) is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The index consists of the following 21 developed-market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index (MSCI EM GR) is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. The index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.

S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value.

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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