Introduction

Investing for income is possible even in this environment of low interest rates. Income investing means that you have to take some risk with your capital to achieve these returns so it is important to understand the risks. In this blog we discuss current dividend yields and the risks involved.

Falling Risk-Free Rates

The problem for income investors is low risk-free rates 

Below is a graph from the Bank of England since its foundation in 1694. Notice how it spent centuries bouncing around a 5% rate but at the moment it has fallen to record lows.

One way to think of risk-free rates is as a foundation on which are layered all other rates.

Those other rates are like boats on a tidal river. When the risk-free rate falls as the tide goes out then so do the rates on those other investments.

At the moment the tide is pretty much completely out because those risk-free rates are very close to zero and in turn that's pushed down the other yields to very low levels.

In the graph below the blue line represents the US 10 year rate.  You can see from this graph that the tide was going up to about 15% in the early 1980s but since then it has been steadily falling until it reached record lows recently.

Below in red is the yield for AA corporate bonds in the United States. This is a little bit above the US 10 year rate because you would be taking a credit risk and the extra yield compensates you for that risk. 

Notice how when the risk for yield falls on the government bonds the yield on AA corporate bonds fall in line. 

The same is true of junk bonds (below in green) they have the biggest spread to those risk-free rates but when the risk-free rates fall so do those of junk bonds.

As of October 2019, In the UK and in the US we don't have negative rates yet. At the 5 year point in the UK we are not too far away from it as it is below 0.5%.

In Japan rates have been negative for some time and more recently they've also become negative in the Euro zone,  particularly for Germany, which has a very low credit risk.

In the example below, if the income on your investment over the past twelve months was £5 and you paid £100 for that investment then the dividend yield would be 5%.

Low For How Long?

A very important question is how long will we continue to have very low rates?

This  isn't fully understood but one factor is low productivity (e.g. how much each worker produces per hour).

Long-term rates are very much driven by both inflation and growth expectations. If growth expectations are lower (low productivity would tend to push expectations down), then it also pushes down interest rates. 

Below you can see just how bad productivity has been in the UK since the global financial crisis. The trend from 1994 up to 2008 shows fairly steady growth of productivity but notice how after 2008 that rate of growth suddenly comes to a halt. If we had seen that upward trend continue we'd be well above where we are today in productivity terms. 

This seems to be a structural change (e.g. a very long term change), so it's very unlikely that we'll see productivity growth shoot up in the near future. 

There is a very good article from the IFS (Institute for Fiscal Studies) by Jonathan Cribbs and Paul Johnson.

It says that in the last decade we have seen record after record broken. These are not good records; low earnings growth, low interest rates and low productivity growth. There has also been record public borrowing alongside record cuts in public spending with economic growth remaining sluggish. 

The demographics are not in our favour because the population is ageing quite rapidly and this points to continued low productivity, low growth and low yields. This productivity story isn't specific to the UK it is a global phenomenon

Reach for Yield

In this low yield environment the natural response from investors is to “reach for yield”. The reason for this is that there are fewer assets which generate high income and so those assets become extremely popular.

As all the good quality assets get bought up their yields go down. The outcome of this is that you then have to reach for ever more risky assets which is also sometimes called “dash for trash” or slightly less politely the “flight to s...”

It is not just retail investors, like you and me, which do that reach for yield, it's also institutional investors like pension funds, hedge funds and insurance companies. 

The reasons why emerging market debt gives you such a high yield is because it's risky. Emerging market sovereigns do default on their debt and you don't have to look far in history to see examples. 

In a low yield environment investors are quite willing to risk their capital in order to get their hands on that extra yield. You can see in the diagram below the movements of capital as investors buy emerging market debt. 

The natural response of companies in emerging markets is to say fine there's a demand for my debt so I'll issue more particularly if that debt can be issued at a very low borrowing cost.

We saw that rise between 2000 and 2008 and then there was a dip during the global financial crisis. It then started again and there has been huge issuance in emerging markets of corporate bonds. 

One of the risks of these reaches for yield is that we have a buildup of low quality debt. At some point there has to be a day of reckoning, so it pays to be cautious when you see this kind of behaviour. 

Another way of looking at that is in terms of the risk that you have to take.

Below on the x-axis we have the volatility of each of those funds, with high risk on the right and low risk on the left. On the y-axis we've got the income,  with high income at the top of about 5% and low-income at the bottom at about 1%.

If we consider inflation is at 2% that rules out the very bottom of the graph because those funds would currently give us a negative real yield.

I've shown equity as triangles and you can see that equity dominates the right-hand side of the graph because equity tends to have a high risk and a high volatility. Bond funds I've shown as circles and you can see those are on the left of the graph because they tend to have lower volatility.

Ideally we'd be looking at low-risk high-yield funds in the top left corner but as you can see there aren't many of them. US dollar denominated emerging market government bonds are fairly good but they do come with quite a high volatility of almost 10%. US investment grade bonds have a much lower volatility but also a much lower return of about 3.2%.

The colours on the graph tell you the cost of the fund and I've split it into three groups. Blue have the lowest ongoing charges, green is intermediate charges and red is high charges.

Unfortunately many of the high-yield funds tend to also be red and that's partly because the underlying bonds are quite illiquid. In order to track an index the fund manager has to continually buy and sell the underlying bonds and that's more expensive when the underlying bonds are illiquid.

Below I have done a more general exercise with a list of exchange traded funds (ETFs). I have whittled down a universe of several thousand ETFs.

Using this filter I only look at Sterling denominated funds so they can be bought on the London Stock Exchange in sterling, I only consider large funds which have assets under management of over 800 million and I've created a yield cutoff so anything with the dividend yield of less than 3% doesn't appear on this list.

Below in more detail you can see the list is dominated by iShares funds and the yield goes up to about 5.6%.

The top choices in this list are:

• High-yield US dollar denominated bonds, so here we would be buying junk bonds issued in dollars
• Emerging Market Local Currency Government Bonds

• More US junk bonds and junk bonds with short-duration so you're not taking much interest rate risk
• Next we get the same thing from PIMCO but this fund is sterling hedged so you're not taking the dollar to sterling currency risk
• In the next  fund you get the same bonds but you do take the currency risk 
• Next down is a European equity fund

Then, as before, further down we get some UK equity and finally some property funds from iShares.

If we repeat the plot with volatility on the x-axis and dividend yield on the y-axis what's interesting is that we finally have something in the top left hand corner!

This iShares high-yield sterling hedge fund doesn't take currency risk because it's sterling hedged but what you are taking here is a US junk bond credit risk. The volatility is low but the credit risk is high.

In the credit world volatility is not a particularly good measure of risk. Instead you need to watch out for is a widening of credit spreads and a deterioration in credit quality. If you can get access to the rate at which companies are being downgraded this tends to pick up when you get a credit sell-off.

PIMCO has an even lower risk fund which unfortunately comes with quite a high fee. It is sterling hedged (no currency risk), short term bonds (less duration risk) but you are taking a high credit risk. 

There is also an emerging market sovereign bond fund which is sterling hedged, but the yield on this is a little bit lower at below 5%.

Investing for Income in Emerging Market Government Bonds

I've talked a lot about the risks so now we'll go into a bit more detail on some of those funds to see what kind of risks you're actually taking.

We can start with emerging market government bonds. Below is the iShares JPMorgan emerging market local government bond fund. It is dollar-denominated so you would be taking the dollar currency exposure versus sterling.

This fund is buying emerging market government bonds denominated in their own currency; this means that if it's a Brazilian bond it would be denominated in Brazilian Reals. It is good to see that this fund is quite diversified so there's not a huge exposure to a single country.

If we look at that geographic breakdown you can see that it's only 10% Brazil which is the biggest allocation. If there is an emerging market sell-off then at least you'll have some degree of diversification.

Generally when there is a risk-off move in the markets, as equity markets sell-off and investors get more cautious, emerging market currencies also tend to sell-off.  This would create a double whammy for your fund because people would be pulling money out of the currency and the individual emerging market bonds.

If we look at the maturity then they tend to have fairly long durations. This would mean you are certainly taking some duration risk which results in making a loss if yields rise in emerging markets and a gain if yields fall.

Because this is an emerging market fund the credit ratings tend to be fairly low. 

Anything below triple B is a junk bond and that's about a quarter of the allocation. There is also about one third of single A highly rated debt in the fund and that’s a fairly substantial proportion.

Investing for Income in Developed Markets Junk Bonds

Another type of risk which you can take in order to get some dividend yield is developed market credit risk, which is developed market junk bonds.

Below is an example of an iShares dollar denominated high-yield corporate bond fund, which is sterling hedged so you're not taking the currency risk. 

This fund  gives you diversified exposure to sub-investment grade rated bonds, known as high-yield bonds or junk bonds. You also get some sectoral diversification through different groups of companies; industrials, utility companies and financial companies like banks.

Because the underlying bonds are quite illiquid the ongoing charges figure is quite high at 0.55% but if the yield is above 5% you're not so worried about the ongoing charge figure.

It is a dollar denominated bond fund so the US dominates the geographic exposure at 93%.

If we look at the credit quality breakdown of the fund versus the benchmark, you will see the fund is in blue the benchmark's in black. Anything that's below triple B would be considered a junk bond. Most of this fund is at the highest credit quality of junk which is BB,  but there is one third of it at single B and some triple C

PIMCO also has a short term high-yield corporate bond fund so you do have this alternative to iShares

Below is another example but of a sterling hedged passive fund which is tracking this ICE Bank of America Merrill Lynch 0-5 five year US high-yield constrained index. 

Investing for Income in Property Funds

Property is another source of income but the yields aren't as high as they are for the emerging market bonds, junk bonds or for some of the equity funds.

Below we look at this example iShares Developed Markets Property Yield ETF. This is sterling hedged and it gives you exposure to developed market real estate companies. 

It has a lower bound of forecast dividend yield of 2%. The fund buys listed real estate companies and real estate investment trusts (REITs) from developed countries excluding Greece which comply with this minimum 2% dividend yield criterion 

The geographic breakdown is again dominated by the US at 57%. There however some global diversification with Japan at 9%, Hong Kong at 6%, Germany at 5% and UK's at 4%.

It is also reassuring that you get diversification across different sectors of real estate. For instance if you're worried about retail taking a plunge as Amazon comes to dominate the retail space then that only makes up 20% of the fund. There are also industrial and office REITs, development companies residential REITs and hotel REITs.

Investing for Income in UK Equity Funds

Finally we will  look at an example of a UK equity fund.

Below is the iShares FTSE 100 tracker, it is in sterling and it distributes dividends as cash payments.

The capital gain on the FTSE 100 has been poor compared to other developed market equity markets.The benefit of this is that it pushes up the dividend yield to 4.7% as of 20th October 2019, but unfortunately the volatility is high because it is an equity fund.

Because it is a developed market equity fund the ongoing charges figure is a tiny 0.07% per year. With such a small fee this will be less of a drag on your long term returns. 

You will have seen from this blog that "Yes" it is possible to get a reasonable dividend yield even in this low yield environment. You do however have to take some risks with your capital otherwise you're just not going to get those returns but please do remember to make sure you understand the risks before you take them.

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