In other words, income probably warrants more attention, including from allocators not focused on seeking income. And as noted earlier, income may play a key role in meeting a variety of investment objectives, such as paying liabilities and improving tax efficiency. But it’s important to be aware of the trade-offs that can be introduced when focusing on income or seeking to generate more of it. Below we highlight the need for a balanced approach when pursuing income in multi-asset portfolios, given the potential trade-offs between income and capital return, risk and portfolio diversification.

Trade-off 1: Income vs capital return

Total return is a combination of capital return (the growth of the capital invested) and income return (the interest received on that capital). Looking across asset classes, the relationship between capital return and income return generally changes as the level of income changes. In short, generating higher income in multi-asset portfolios tends to come at the expense of capital return. This does not mean that total return decreases, but rather that the mix of capital and income returns changes.

We examined these dynamics for a variety of asset classes since 1995. As shown in Figure 3, we didn’t find a clear relationship between income and total return. Moving into asset classes with higher income didn’t change the total return expectation; i.e., there was no trade-off between income and total return.

Figure 4 shows why this was the case. In asset classes with higher income, capital returns were lower. Generating more income essentially meant shifting some of the expected return to income while keeping the total return relatively consistent.

Figure 3

Figure 4

To understand why this trade-off exists, consider the example of high-yield credit. Allocators can potentially increase expected income in their portfolio by adding exposure to higher-yielding bonds, but doing so will increase credit risk. This means they are more likely to experience defaults that lead to a negative capital return. High-yield bonds may also have limited capital return potential as they typically trade below or near their par value, given they typically have short maturities, and many are callable.

For allocators seeking income in multi-asset portfolios, it may be prudent to strike a balance between income return and capital return, which can each be important for different reasons. Focusing too heavily on high-income-producing assets may not only limit capital appreciation potential, but also restrict the opportunity set. For example, commodities generally produce little income, but they have important inflation-mitigation characteristics.

Figure 5

When increasing the income target in an asset class, especially into the yellow and red regions of this chart, it’s crucial to consider the potential for unintended and uncompensated risk. Income opportunities and risks will, of course, change over time, which means it may be important to have a somewhat dynamic investment process.

Trade-off 3: Income vs diversification

Diversification is typically the key benefit of allocating to multiple asset classes, and therefore it’s important to note that seeking higher income within an asset class can alter the relationship between that asset class and others in a portfolio and potentially reduce diversification. This is particularly true for fixed income, where higher-income bonds have historically had a more positive relationship with equities.

Figure 6 shows that seeking higher income within fixed income can significantly reduce the diversification benefit of holding equities and bonds by raising the correlation between the two. What explains this change? Fixed income returns have two key drivers: rate duration and spread duration. Rate duration is the dominant driver in the lower-income parts of the fixed income market, which makes them more diversifying to equities (assuming inflation is under control). In the higher-yielding areas of fixed income, spread duration is the dominant return driver, which leads to a stronger relationship with equities and a worsening of the equity/bond diversification benefit.

Figure 6

Figure 7, on the other hand, shows that higher income in equities has meant only a slightly stronger relationship with fixed income. This might seem counterintuitive, because lower income in equities is associated with “growth” stocks, which have cash flows that extend further out into the future and therefore, in theory, have a longer duration and a stronger relationship with bonds. However, this force is counteracted by the fact that higher-income equities typically have lower equity-market beta and are thus more “bond-like” in their behaviour — i.e., more defensive with the potential for more consistent returns.

To help retain diversification when seeking higher income, we think allocators should:

• Consider the portfolio diversification impact and seek to strike a balance to avoid unintended portfolio risk consequences
• Ensure there is sufficient rate-duration exposure from bonds with low credit risk, to retain the diversification benefits of fixed income
• Consider other income sources that may be less correlated to those currently in the portfolio, such as options writing

Summary and conclusions

Income is important for many allocators and may contribute significantly to long-term returns while potentially providing several other benefits to multi-asset portfolios. When seeking higher income, allocators should be aware of the implicit biases and trade-offs that may be introduced:

• Focusing on higher income may mean sacrificing some capital return. Allocators may want to seek a balance between these two objectives, allowing them to maintain access to a range of asset classes while creating opportunities for long-term capital growth.
• Generating higher income within asset classes can introduce additional, potentially unintended risks. Allocators should monitor these risks to ensure they do not cross the threshold at which seeking higher income may be detrimental to portfolio outcomes. They may also want to build some dynamism into the investment process so that they can move into income opportunities when the cross-asset relative risk is lower.
• Pursuing income may have an impact on portfolio diversification, necessitating the use of other asset classes to maintain a well-diversified asset mix.

Income can potentially play a vital portfolio role, providing stability and helping to meet specific financial goals. By understanding and navigating the trade-offs, allocators may be able to enhance their portfolios to deliver a well-balanced blend of income, capital return, risk management, and diversification, ultimately ensuring that income generation does not compromise other essential investment objectives.