The dominant driver of returns
Income is the dominant driver of most asset class returns over the long run. For some asset classes, such as high yield corporate bonds, the income received can even exceed the total return due to a portion of capital being lost to defaults. Even for equities, reinvested dividends are typically responsible for more than half of cumulative total returns over time. We’d argue that this understates the importance of income to stock market investors. What’s more, buy backs provide an additional route by which cash is returned to shareholders.
Figure 1: Income beats capital appreciation as source of returns over the long run
Past performance is not a reliable indicator of future results, losses may be made.
Source: Ninety One, Bloomberg as at 31 December 2019. Data since 30 November 1998. *Since Inception: 31 December 2005. A positive yield does not imply a positive return.
Given the importance of income, the decline in yields on most asset classes since the global financial crisis (GFC), and the further fall during the COVID crisis, appears to bode ill for future return potential. Central banks have doubled down on using ever-looser monetary policy to stimulate economic activity. Official interest rates have been cut to very low or negative levels in most developed countries and balance sheets have been used to buy bonds, pushing government yields close to zero or even below in many cases.
The definition of madness
One definition of madness is repeating the same action but expecting a different result. That hasn’t stopped policymakers from believing that looser policy will eventually generate higher growth and inflation. For this strategy to work, they now believe that low interest rates and quantitative easing will probably be needed for the foreseeable future. The US Federal Open Market Committee, for example, is not expecting to increase interest rates at all over their entire three-year forecast horizon.
"One definition of madness is repeating the same action but expecting a different result. That hasn’t stopped policymakers from believing that looser policy will eventually generate higher growth and inflation"
Best yield premia in years
The good news, however, is there are still attractive yield premia to be earned across a range of asset markets and securities. The yield advantage over government bonds offered by corporate bonds and emerging market debt is above the median level that has prevailed over the last twenty or so years.
In addition, the earnings income premium offered by global equities is also above the average seen since the GFC, and well above the levels that prevailed for the two decades prior to that.
Even in government bond markets, there are opportunities to earn relatively attractive yields in state and provincial bonds, and, selectively, in longer-dated maturities given upward-sloping yield curves.
Figure 2: Asset class yield differentials versus G2 government bonds
Source: Bloomberg, Ninety One calculations, December 1990 to May 2020. Global equities: MSCI World Index, High yield: BofAML Global High Yield Constrained Index, EMD: EMBI Global Diversified Index, G2 = US and German 10y constant maturity yield.
These yield premia exist for a reason, however, with plenty of businesses and borrowers in financial distress. We have already seen a slew of dividend cuts, especially in sectors which were already under pressure, and are now beginning to see company failures and defaults.
What’s the answer?
The answer, then, we believe, is to be selective in what to own and what to avoid. History shows that the highest-yielding assets are often compromised and can deliver disappointing returns with significant risks. The yields they offer are essentially illusory, because their underlying assets struggle to generate sufficient cash to cover their income payments. Better returns for less risk can generally be found in moderately high-yielding securities where the yields are properly underpinned by resilient excess cash flows. At the security level there are many such opportunities to be found, you just need to look for them.
Look for the oases, not mirages
In essence, investors need to distinguish between investment oases and investment mirages.
Figure 3: S&P return characteristic ranked by dividend yield percentile
Over the past 20 years stocks in the S&P 500 (the index about which we have the longest and most detailed information) split into 10 groups ranging from Group 1 (the highest 50 yielding stocks) to Group 10 (the lowest 50 yielding). The numbers in the table indicate the respective rank for annualised return, volatility and max drawdown - based on what is a desirable characteristic. 1 is the best (green), 10 is the worst (red). Ranking their return profiles by key metrics shows the advantage of focusing on Groups 2 to 4. A positive yield does not imply a positive return. Source: Ninety One, Bloomberg November 2018.
In the equity market, the former are more likely to be found in companies with a mix of above-average dividends, supported by excess cash flows, but with lower leverage and higher profitability than their peers, providing dividend resilience, priced at valuations which suggest there is potential for capital upside or at least stability. This is in contrast to a typical dividend strategy which focuses primarily on the absolute level of yield and how consistent it has been.
The latter approach can prove to be a mirage and leave investors exposed to companies who have simply leveraged up their businesses to maintain high dividends. In the current market, for example, within the healthcare and staples
sectors there are a number of stocks offering above average yields, but with earnings growth which is organic and relatively stable. This provides a backstop to their dividends, with valuations that have decreased significantly in recent times.
By contrast, we can find few similar opportunities amongst higher-yielding equities in the utility, telecommunications and European banking sectors, where many companies are subject to regulatory restrictions on dividend payments, or
which have built up high levels of debt to prop up dividend payments despite low and volatile earnings reducing their resilience over the long-run.
The same approach of looking for sustainable cash flow generation to underpin yields applies equally in fixed income markets. Currently, we see decent value in a number of bonds issued by developed market investment grade-rated borrowers, supported by strong balance sheets and resilient income, as well as some equivalent emerging market issuers. Yield premia for the latter, typically remain well in excess of developed issuers of comparable credit quality. They entered the COVID-19 crisis in good health and management have prior experience of managing market volatility and leverage through economic difficulties. Many BB-rated high yield bonds, in contrast, have limited room for capital gains from any further fall in yields, due to embedded call features, but remain exposed to losses in the event of higher yields, downgrades or defaults.
So, for us, the key to thriving in this income desert is to build a diversified portfolio selecting attractively priced individual bonds and equities offering decent yields, but whose income payments are well covered by sustainable cash flows – the
oases, not the mirages.