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Income is probably more important than many asset allocators recognize, even those focused on accumulating capital over time. Our research suggests that even for a standard 60% equity/40% bond portfolio, income can potentially contribute more than half of the returns over a five-year investment horizon. For asset classes with a higher income profile, income could contribute even more — over 80% of the total return in some cases. Among the potential benefits of income are return consistency, the ability to meet cash-flow requirements and tax advantages.
But when focusing on income, and especially when seeking to generate even more of it, allocators should be mindful of the implicit biases, risks and trade-offs that could arise. Specifically, we think that being aware of the following trade-offs may help allocators find a balanced approach to the pursuit of income in multi-asset portfolios:
In this paper, we touch briefly on the importance of income and then delve into our research findings on the trade-offs allocators face and how they can be factored into portfolio decisions.
Our research considered the five major sources of investment income, with a focus largely on the first three:
Despite the variety of available income sources and strategies, allocators tend to pay more attention to capital return than to income return — perhaps because there is more noise in the asset prices that drive the former on a day-to-day basis, while the latter is typically a small proportion of the total return. But in the long term, income can represent a much larger proportion of the total return, given the consistency of income returns and the effect of compounding.
Figure 1 shows that for a 60% equity/40% bond portfolio, income has made up less than 20% of the return in any given month but represented half or more of the return experience over 5+ years. Figure 2 shows that this proportion was much higher for fixed income investments, particularly credit, and high-dividend-income equity strategies.
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.
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.
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.
As we’ve noted, there are numerous potential benefits to seeking income from investments, but there are also limits to how much income can be achieved without introducing negative biases or risks in a portfolio. We think that being aware of the additional, sometimes unintended risks can help allocators better gauge the threshold at which seeking higher income may be detrimental to portfolio outcomes.
To examine this issue, we focused our analysis on the primary risk associated with the pursuit of higher income in each asset class. For equities, the focus was on concentration risk, given that the opportunity set shrinks when one targets stocks that pay higher dividends. For government bonds, the focus was on duration risk, and for credit, it was on credit risk. Finally, for call options writing, we looked at strike risk, which is the increased risk that an option gets called as the strike price is lowered. While there are other risks to consider, we think this simplified approach provides a clear indication of the trade-offs investors may face.
Figure 5 shows our “CARRY landscape”, which plots the current income level within each asset class in exchange for taking low risk (green), medium risk (yellow) and high risk (red), as defined in the table. This can be used to help find the right balance between income-producing investment opportunities and one’s risk tolerance.
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.
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 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:
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:
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.
IMPORTANT DISCLOSURES
BAC data in Figure 5 — The use of the data in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided “as is” and neither BAC nor any of its affiliates warrants the accuracy or completeness of the information.
Volos data in Figure 5 — Neither Volos Portfolio Solutions, LLC (“Volos”) nor any other party guarantees the accuracy and/or the completeness of the data included therein. Neither Volos nor any other party makes any warranty, express or implied, as to results to be obtained from the use of the data included therein. Volos expressly disclaims any liability for any errors or omissions in the data and no party may rely on any data contained in this communication. Volos does not promote, sponsor or endorse the content of this communication.
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