Jan 18, 2021

WHAT IS THE FUTURE OF INCOME? 

It is an inescapable fact that the world has changed. It is also becoming increasingly clear that income-oriented investors will feel the impact deeply. At a time when Boomers, the largest demographic cohort in history, are retired or nearing retirement, interest rates and bond yields are at their lowest point. This has created a veritable income famine and may require many to either take on more risk, eat into capital or scale back their lifestyle; none of which are particularly palatable options for retirees. Financial professionals will need to design portfolios that deliver sufficient income to sustain privileged lifestyles over an ever-expanding lifespan. 

Meeting investors’ growing needs for safer, more predictable returns and reliable sources of income in an era of multiple once-in-a-lifetime crises is the greatest challenge facing financial professionals going forward. 

NEW REALITIES

When Boomers were establishing themselves in the 80s and 90s, they looked to advisors to “make me rich”. In late 1981, 10-year US treasuries were in the process of dropping from an all-time high of almost 16% and a bond bull market of unimaginable length was underway. Investors received outsized returns, and over time, an unintended consequence was a growing tendency to treat fixed income investments as the set-it-and-forget-it portion of their portfolios. 

As Boomers entered their sunset years, the investment zeitgeist changed from “make me rich” to “keep me rich”. Surveys over the past couple of years have confirmed that, for the first time in a very long time, investors now prioritize capital preservation over capital growth. Although some may not yet recognize the subtle shift to a “win by not losing” mindset, the trend will only strengthen in the face of growing longevity. The duality of wanting to be more conservative while needing to take on more risk will challenge advisors’ ability to manage expectations like never before.

SHORTCOMINGS OF CONVENTIONAL APPROACHES TO INCOME

GICs

GICs are savings products, not investment products, but recently we have noticed that more financial professionals seem to be incorporating them into their clients’ portfolios. Locking investors into savings at historically low interest rates seems like an abdication of duty. While the returns are indeed guaranteed, the real rate of return is also guaranteed to be flat at best, and negative at worst, especially since interest income is taxed at everyone’s marginal rate. Add illiquidity and the fact that recommending GICs in an investment portfolio runs counter to the brand of an investment advisor and there is much cause for concern.

CANADIAN GOVERNMENT BONDS

Short-term treasuries all the way out to 10-year Canadian treasuries currently offer yields of less than 1%. Something else they offer is an extraordinary level of risk, especially in the long end of the curve. This is due to expected reflation that will inevitably occur due to the extraordinary fiscal and monetary stimulus that is being thrown at the COVID health and financial crisis. A lengthy period of declining rates has conditioned many to believe that rates will never rise. Maybe not now, and maybe not next year, but sometime sooner than we anticipate, rates may begin to normalize. This will put a great deal of stress on a portfolio of treasuries that is not actively managed.

NORTH AMERICAN DIVIDEND PAYING STOCKS

Dividend paying stocks have historically provided a valuable hedge against inflation. Companies that pay dividends are typically well established in their industry and able to weather economic adversity better than growth companies. Dividend paying equities offer a combination of safety, income and long-term steady growth which make them very attractive for investors during times of crises. These qualities mean that this asset type has become a very crowded trade during the current crisis.

INVESTMENT GRADE & HIGH YIELD CORPORATE DEBT

The thirst for income has driven demand for investment grade and high-yield corporate bonds. These bonds are an attractive complement to treasuries because they are often less sensitive to changes in interest rates. Corporate bonds offer investors significantly higher yields than treasuries, but they also come with default risk. They have become more attractive during this period of historically low rates and yields have been coming down, making it more difficult to realize value.

NEW POSSIBILITIES FOR GENERATING INCOME

1. EMERGING MARKETS DEBT

Since the Asian Contagion of the late 90s that created a crisis right across the region, policymakers have put their fiscal and monetary houses in order, and importantly, continued to behave responsibly. Unlike developed market policymakers who have employed extreme measures, emerging Asian economies possess all the tools in the kit to effectively manage economic adversity. It is unlikely that they will need those tools any time soon though as many EM countries have overwhelmingly favorable conditions for growth with younger demographics growing middle classes and burgeoning consumer economies and GDPs. Emerging Asian debt offers very attractive yields with very positive risk characteristics for investors who understand the market.

2. CURRENCY EFFECT

The global currency market is the largest, most liquid market in the world. It has also been among the most non-correlated and volatile market since the Global Financial Crisis. This has provided Forstrong a significant advantage over other global asset managers who are largely currency inert; choosing to remain either hedged or unhedged. Forstrong believes that the U.S. dollar has begun a long-term secular downtrend that will usher the most significant change to the currency market since the advent of the Euro. China’s economic ascent and the renminbi’s inclusion in IMF SDR, signifies its trajectory toward global reserve currency status has begun. Although the U.S. dollar will remain the dominant currency for some time, Forstrong envisions a tripolar economic order with distinct American, Eurozone and Emerging Asian economic hubs. Currency management will become an even more important weapon for managing risk and return going forward.

3. ACTIVE MANAGEMENT

Going forward, realizing meaningful income will require that investors venture out on the risk spectrum. Whether advisors choose traditional or non-traditional approaches, or some combination of each, the set-it-and-forget-it era of income generation is most definitely over. Growing risks associated with heightened economic, geopolitical, social and environmental uncertainties will require investors to pay attention and be ready to act. Investors will have to be very selective about their exposures in a rapidly changing world. Managing fixed income passively off the corner of one’s desk may well become a dangerous strategy once rates begin to normalize.

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