Income’s ability to not only generate consistent income streams but also act as a powerful driver of returns makes it a crucial component in today’s investment portfolios, where the path to returns may be rockier than it has been in the past.
The when — income from cash is good but income from bonds is better
Despite the benefits of income investing, many investors remain wary of the asset class most often associated with income — bonds. This is perhaps understandable, given fixed income’s record underperformance in 2022. The fact that cash is yielding more than some bonds is, for many, another mark against fixed income. Add to this a mixed economic outlook, uncertain monetary policy and a tense geopolitical environment, and it’s not really surprising that significant numbers of investors are choosing to hold cash while waiting for a clearer trajectory to emerge.
The problem here is that waiting for more certainty before moving out of cash and into bonds could come at a cost, in the form of a lower total return. Based on our analysis of the past six US Federal Reserve interest-rate-hiking cycles, when interest rates are at (or near) their peak, moving from cash into fixed income has been rewarded with higher total returns. We ran the same research for the Bank of England and the European Central Bank and found similar results, with global fixed income being more compelling than cash, even after considering the cost of hedging the currency exposure. Crucially, being early had a positive impact on returns, capturing the market’s tendency to prematurely price in rate cuts.
The how — attractive fixed income opportunities exist, but diversify into other sources of income
Income’s ability to contribute significantly to long-term returns, alongside other benefits, means that, in our view, investors should continue to keep income front of mind when building portfolios. This is especially true in a more volatile investment landscape, where consistency of returns may be challenged.
However, this doesn’t mean that investors should only target the highest-yielding income-producing asset classes in an effort to generate as much income as possible. While higher-yielding asset classes can have their place in a portfolio, maintaining a well-diversified portfolio is crucial. Some asset classes may not produce much income but bestow other benefits for income-seeking investors, such as capital growth or inflation mitigation.
In a more volatile world, greater dispersion and divergence should continue to evolve income opportunities across asset classes. While bonds are currently an attractive source of income and return enhancement, the new macroeconomic environment should, however, also prompt investors to diversify into other areas, such as equity income, high-yield bonds, property or REITS, or potentially call option writing strategies. These asset classes can provide income alongside other desirable portfolio characteristics.
For this reason, many investors may benefit from a dynamic investment approach, retaining an element of flexibility so as to navigate new opportunities when they arise.