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Income investing in multi-asset portfolios: Tipping the balance in your favour

Multiple authors
2024-09-30
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

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:

  • Income vs capital return — Investing in higher-income asset classes tends to mean that more of a portfolio’s total return comes from income and less comes from capital return, and often with a trade-off — so more income doesn’t necessarily mean higher total return.
  • Income vs risk — Generating higher and higher income within asset classes can lead to additional risk, such as increasing the concentration risk in equities or the credit risk in corporate bonds. As this income vs risk relationship is not consistent across asset classes, it may be possible to generate the same level of income from another source and avoid taking unnecessary risk. We have developed a framework to help allocators compare the potential income opportunities and risks levels of various asset classes — what we call our CARRY (cross-asset risk and relative yield) landscape.
  • Income vs portfolio diversification — In a multi-asset portfolio, seeking higher income can, beyond a certain point, reduce diversification — the key benefit of a multi-asset portfolio. For example, adding to higher-income assets in a fixed income allocation can increase the correlation with equities.

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.

The sources and significance of income

Our research considered the five major sources of investment income, with a focus largely on the first three:

  1. Dividend income — Income paid to shareholders out of a company’s profits
  2. Government bond income — Income paid to holders of government debt at a fixed rate over a set period
  3. Credit income — Income paid to owners of fixed income investments, typically issued by corporations, that provide a fixed rate of income directly linked to the creditworthiness of the issuer
  4. Property income — Income generated by real estate investments such as rental properties or real estate investment trusts (REITs)
  5. Options income — Income resulting from the sale of equity options contracts to other investors, producing a premium in exchange for the obligation to buy or sell a stock at a specified price in the future

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.

Figure 1
income-investing-multi-asset-portfolios-fig1
Figure 2
income-investing-multi-asset-portfolios-fig2

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
income-investing-multi-asset-portfolios-fig3
Figure 4
income-investing-multi-asset-portfolios-fig4

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.

Trade-off 2: Income vs risk

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.

Figure 5
income-investing-multi-asset-portfolios-fig5

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
income-investing-multi-asset-portfolios-fig6

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.

Figure 7
income-investing-multi-asset-portfolios-fig7-1

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. 

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