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Richard Edgar Things aren't easy for income investors. There are now $12.5 trillion dollars of debt around the world with negative yields and the hunt for positive yielding assets continues to drive valuations higher and push investors further up the risk spectrum and that risk is becoming all the more real as volatility picks up, growth slows, and central banks change their tone. All this at a time when the need for income has never been so great as ageing populations around the world need to fund their way through increasingly lengthy retirements. So what can be done? How can investors build portfolios that will safely deliver on income in uncertain times where the rules seem to be turning on their heads? With me and poised with their answers are three Fidelity portfolio managers each focused on income strategies but each representing a different asset class. First here in the London studio is Peter Kahn. Peter, welcome. You've got some 25 years of experience investing in fixed income under your belt. What drew you to bonds?
Peter Kahn Well, believe it or not Richard, I was foolish enough to leave the beginning of the first tech bubble 1.0 back in San Francisco in the mid to late 90s.
Richard It was possibly a good time to leave.
Peter Well it might have been. Timing is everything, of course, they say. But for me having started out my career in financial markets with the focus on equities that was to me a little bit of a one-dimensional market at the time - or so I thought - and I was very much more attracted to thinking about multifaceted impacts of the combination of the bottom-up stuff together with macro factors that tend to dominate in fixed income spaces - that sort of puzzle appealed to me.
Richard So complexity was it was part of the appeal for you.
Peter Well said.
Richard Okay, well also here in London from the multi asset team is Chris Forgan. Now, Chris, income is often seen as one of the more defensive styles of investing. Are you yourself cautionary by nature? Does this explain your career?
Chris Forgan Yeah, I think I think it probably does actually. Certainly how I was drawn into this particular area of investments. I look at what’s attracted me over the years in terms of investment styles and managers and I think have a natural cautionary nature that underpins what I do and that very much is at the heart I think of a multi asset income approach.
Richard It seems like it was predestined then, Chris.
Chris Yes. Yes.
Richard Okay. Well joining us from Fidelity's Hong Kong office representing the equity team in Asia is Polly Kwan. Polly, welcome to you. You've been based in Asia for all of your career - not typically regarded as a region with much of an income focus. How did you end up managing a portfolio with that income focus?
Polly Kwan I started at Fidelity in Tokyo back in 2000 where there was an increasing push of capital management and also return to shareholders in that country. So I witnessed that companies which did more shareholders returns got more appreciated by the market in terms of share price performance. So that's how I have a bigger belief in terms of dividend payments. And also later time moved to Hong Kong from Tokyo and started covering property. Property is a sector that needs more balance sheet and cash flow analysis - that helps me to do my job today because if you want to invest in a company that can pay you dividend today and tomorrow you need to take an all rounder approach looking at not just P&L but also balance sheet and cash flow.
Richard So it's a rounded view that appeals to you, as well.
Richard Okay, well thank you all very much for joining me. Now, Peter, let's come back to you. We're in a new world, aren't we: the traditional reliable income assets - government bonds, high quality corporate credit - they're not doing what they used to. Are investors keeping up with this new reality?
Peter It's very difficult to keep up with the new reality of basically return-free risk in those high quality segments that used to be the foundation of investors’ portfolios, particularly low risk tolerance investors just looking to clip a coupon to keep up with inflation. The degree of financial repression that we have today…
Richard It certainly doesn't sound very appealing.
Peter No. It implies that you need to stretch a little bit to... basically run to stand still. In keeping up with inflation, with generating an income stream from fixed income assets now implies that you've got to go down in quality, not necessarily too far down in quality but you certainly need to introduce some asset classes into the mix of asset allocation in your portfolio that traditionally wouldn't have been there in past days. So I mean specifically things like high yield bonds and emerging market corporates and to a certain extent hybrid instruments can be the sort of additional spice in a portfolio that on a well-diversified basis will allow you to achieve what it is that that you need on an income basis.
Richard So you've got to get a lot racier with your fixed income allocation which perhaps people haven't been used to and that's the worry.
Peter That's right. And I mean we've been hopeful that we would leave these times behind, these special times post financial crisis that were seen, even last year, as potentially an anomaly. Now that we are so deep into the expectation of QE 2.0 or QE infinity the idea is that we really must say that the new normal perhaps endures for a lot longer than we previously thought and that of course has led to this buzz word of ‘Japanification’ or ‘Japanisation’, depending upon who you speak to. This sort of locking in the low rate, low inflation, low growth environment in perpetuity is at the top of investors’ minds.
Richard And Polly that's the area of course that you talked about. You started your career in Japan and it’s a country that's had to deal with this sort of environment for a very long time. Talking about your clients outside Japan though how are their demands changing when you're talking to them about income equity strategies?
Polly Asia has always been perceived as a growth-only kind of region. However, I have to say that the attitude both from the management side and also from the investor side have changed over time. I mean, of course, you know with this low interest rate environment naturally people are seeking a higher income, but also it has to do with the demographics itself. I mean in Asia we are no different from other parts of the world. If you look at it overall we are facing an ageing population. So with an ageing population actually more investors want to have income on top of growth. So when they think about Asian equity, if you are investing into something that has long term growth - we still believe there is a long term growth potential in Asia equity - but along that journey you'll receive some dividend payments. This is something very, very nice to have, especially for an ageing population.
Richard We’ll come to demographics in a moment but just thinking about the company managements that you talk to. You're saying that attitudes amongst them are changing, that they're beginning to be more prepared to hand over dividends. Is that right?
Polly Yes, because a lot of the corporates in this part of the region they suffered in the crisis in terms of their share price. They have been thinking hard about how to have a more stable kind of share price and they know that there's a need from the investor side that they will appreciate some kind of sustainable and consistent dividend pay out that will have good support to the share price. So that attitude has also changed.
Richard One way of making your shares stickier, I suppose, for people hanging around for that as well.
Richard Chris, coming to you. People are looking for new, clever ways to generate income. Is multi assets benefiting from that?
Chris Yeah, absolutely. I think multi asset has seen huge growth in terms of demand, in particular for income solutions. We can go where we see opportunities and we can retreat from areas where we see threats. And as Peter alluded to earlier, you think about your traditional income assets and your government bonds, your high quality investment grade, which are certainly lower yielding today than they historically have been. We can continue to hold those assets for their defensive characteristics but blend them with other assets such as high yield, such as equity income, both from Europe but also from Asia as well.
Richard And alternatives as well, I imagine.
Chris Yes. This is the other exciting area that somewhat exploded in the last 10 years, post the financial crisis, is the onset of the alternatives universe where we're able to access some attractive opportunities both from a return perspective but also from an income perspective. When I talk about alternatives I’m talking about things like infrastructure, renewables, loans, and asset leasing-type vehicles. The drivers of these asset classes are often quite different to what drives mainstream asset classes - equities and bonds - and so when we bring them into a portfolio and blend them with these other asset classes it’s clearly very additive in terms of delivering a lower volatility outcome for the end client.
Richard What are you looking for when you do build a portfolio? Just briefly describe how do you do that blend. What's the recipe?
Chris Well, we're very much looking at the opportunity set in front of us. Does this asset from the fundamental level look to be offering value going forward? Are we getting paid to take on the associated level risk? What's the driving force of that risk underpins it today? And what's the income generation and how does that therefore sit alongside the other assets could be potentially could invest into? In terms of the portfolio, is it adding exposure to something we already have or is it bringing something differentiated to the overall portfolio mix? And obviously if it's a latter - and in particular with alternatives that's what you get - then it adds value to the overall portfolio mix, particularly in terms of delivering a diverse well diversified portfolio often with lower levels of volatility.
Richard So that's the appeal of alternatives, that you're getting a different type of revenue stream, but you've all talked about this different world where the usual sources of income just aren't there. Thinking about the particular assets that each of you is looking for for income, if everyone else is piling in and seeing the appeal of bridges or whatever it might be then aren't the prices of those assets driven higher as well?
Chris Yes. In a lot of ways they react in manners we've seen with traditional asset classes over the years so therefore we appraise them the same way and if the price of the asset has been driven higher and we think that's ultimately made the asset expensive or it's unsustainable then we'll clearly look to retreat away as we would with any and any other investment.
Richard You make it sound so simple. Peter, how about you? Is it just going further and further up the risk spectrum?
Peter Interestingly, I mean Chris is absolutely right in terms of the forces that are at play that you've highlighted. But in thinking about an income focused portfolio, particularly within fixed income, that definitely creates an environment where you tend to, in sort of extreme euphoria cycles, you tend to see that dash for trash kind of dynamic kicking in and people going all the way down into the most remote and illiquid assets that they can find in order to extract that additional value that they believe is there. And we haven't necessarily seen that happening year-to-date within fixed income market performance. If you think about the high yield market for a second on a risk-adjusted basis it's actually the higher quality elements of the market that are producing the best returns year-to-date and that's because investors are indeed discriminating and concerned about a combination of factors notably liquidity and the potential for default losses to impair their values further down the food chain. If and when we do get a recessionary environment developing in the US economy or the European economy then you'd really anticipate that the lower quality assets are going to need to offer a much better compensation for the intrinsic risk that you're taking than they do today. And we have a bit of this investor schizophrenia going on at the moment in that people are getting crowded into as much income that they can possibly acquire but they’re, at the same time, afraid of taking that final step down into the mire, if you will, to pick up the juiciest of assets because they just don't know how deep that swamp can be - to completely mangle the allusion there.
Richard Yes, whatever it is it sounds grim. Polly - the dash for trash: that's perhaps not how you would describe finding income in equities.
Polly I do agree that over the short term when there is a chase of yield then the higher dividend yield stocks become very expensive compared to where they should be. However, there is a difference if you want to invest into the long term. I always tell people, do not only look at today's dividend yield but you want a company who can pay you today also who can pay you at least the same amount of dividend tomorrow. So don't fall into that dividend trap, that I would call it. Having full analysis not only on the P&L but also very solid analysis on the balance sheet and also cash flow to make sure that all the companies are going to pay at least as much dividends that they can pay today tomorrow. So that is the difference and there’s still a lot of stock picking opportunity.
Richard So that's the analysis you can do just looking at a spreadsheet. What about the conversations that you have with managements? What do you look for there? What gives you confidence about the dividend tomorrow?
Polly Investing using a dividend strategy - company visits and doing due diligence with a company is very, very important. I think if an analyst does a decent job in terms of looking at the dynamics in an industry, the balance sheet, cash flow, they can do a good forecast in terms of earnings, but whether a company will pay you a dividend tomorrow: it comes down to the management decisions. So knowing the management well enough, knowing the track record, knowing their thinking - any concern, any investment plan that they may have in the next 12 to 24 months - that makes a big difference. That actually is part of a major step I need in order to assess whether a company will make that dividend payments that I'd expect in twelve months’ time.
Chris It's definitely fair to say that when you think about equity income investing it actually tends to on the whole be the more defensive area of the market you get exposure to. You see that particularly in risk-off periods in markets that traditional equity income investors tend to perform certainly better than the wider market on average. You saw that certainly through the volatility we saw last year, particularly in Q4, where the natural defensive nature of a lot of these managers or investors comes to the fore. So it's a positive that underpins that approach.
Richard And capital preservation?
Chris Yeah, absolutely. Very much about strong balance sheets, cash flow generative companies that can maintain the dividend over time.
Richard All three of you are sort of nodding at that aspect. Peter, I mean how do you build that in? That thinking.
Peter Well, I think there is a lot of common aspects in what Chris and Polly have said and a lot of correlation between these different flavours of income products that we're trying to manage and deliver superior returns for clients. A lot of that correlation to interest rates will mean that we tend to move together but there can be significant differences in alignment of interests between management, creditors and shareholders over time. So it's interesting to hear what Polly has to say in terms of the priorities for her screening companies, and Chris as well, in portfolios whereby you have confidence in the ability to generate growth in cash flow to service the dividend. That's clearly one part that's very important for a credit analyst to think about as well, but when the rubber hits the road we may also have comfort and confidence as bond holders to own names …
Richard You come first.
Peter Exactly. So when push comes to shove the dividend can be switched off to the benefit of interest service or assets can be sold and depending upon the nature of the documentation, around the bond instrument in question. The proceeds of that asset sale may or may not need to be delivered to creditors. So that's an additional factor that we'd be thinking about where naturally we'd have the same inclination as our colleagues in multi asset and equity to say, we'd like to back off of a name that simply is not able to continue growing and its capital structure may no longer be appropriate for it, but if there are enough levers to pull in the balance sheet or in the cash flow to divert down that debt sluice rather than dividend sluice then we may still be comfortable and confident enough to own some aging industries, if you will.
Richard You might go where Polly fears to tread.
Peter We might, which sounds perverse, right? Given an investor might think fixed income should be more risk averse than an equity investor. But it’s just thinking about the combinations and permutations of available capacity to service the debt where things diverge.
Richard Now you're both obviously sometimes looking at the same companies just different instruments from them. And you alluded, Peter, to the fact that a credit analyst might also be looking at some of the same indicators from a company. How much cross pollination is there between the two sides though from equities and fixed income? How much do you look at those same companies together?
Peter Increasingly. Certainly on the financials side there's been a lot of good coordination for many, many, years on this front. Particularly going back to that post financial crisis episode where the global financials needed to raise a lot of capital - credit analysts working very closely together with equity analysts to really understand what was on the balance sheet and what the value of that might be, how much capital cushion is required is kind of integral to the thinking about how we might want to position ourselves in the debt capital stack of national champion banks in Italy, for example. And it's increasingly happening more in industrial space, technology space, and consumer space as capital markets grow around the world and we see new issuers coming to the market from regions outside of developed markets. To have the context of understanding where that kind of business, that kind of capital structure might trade elsewhere in the world, and then overlay some additional thinking about, well this jurisdiction is a little bit more risky or these instruments are a lot less liquid than those that we naturally see, helps us to calibrate and develop an expectation.
Richard And Polly, it may be a blessing that you don't invest in Italian banks, for example, but how do you combine that different view in your approach?
Polly In terms of talking about stock picking, I mentioned the P&L - and of course in Asia everybody wants growth - but I look at the balance sheet, whether a company is taking a reasonable level of debt and I need to see a company that can generate free cash flow that can cover that dividend. When companies in Asia, they move to a direction of focusing more on a dividend or setting up a dividend policy, that also leads them to think about the capital structure more. Early on, Peter mentioned about when in a bad time how a company can services its debt - I mean, from my side, because equity shareholders, if things go bad we are the last to collect any money left on the table: in Asia we still want growth but I want them to grow on a very healthy capital structure.
Richard Which is what you want as we get towards the end of the cycle. When that end happens, none of us seems to know for sure, it's been going on for as long as I can remember. Chris, how do you cope with it? How do you cope with unpredictable messaging from central banks, the effect of politics - I won't name them now, it seems rude to - but how does that influence what you're thinking about as you manage your portfolios now?
Chris It's certainly bringing more risks and more challenges to how we look to construct our portfolios. But overall with these heightened risks that we perhaps see on the horizon alongside slowing growth globally at this juncture it certainly points to taking a more defensive positioning to one's portfolio, looking to be more diversified across asset classes and asset types.
Peter Without a doubt, right? I mean the uncertainties that we're dealing with on a day to day basis are very difficult to forecast and very difficult to hedge but they need to be incorporated in the expectations about where things might get to in terms of radical changes in regimes and the market tail seeming to wag the dog of the FOMC policy - the Federal Reserve - at the moment is just one of them that we clearly need to factor into our thinking about how quickly regimes may change. But actually for an income-based investor a lot of this minute to minute and day to day stuff probably creates more opportunity than threat and a lot of it can be considered noise. But if the cycle ends in a way that's unanticipated it will come back to the point that Polly made earlier about quality and confidence in balance sheets that will make a difference particularly for fixed income investors. When you do need to add a little bit of risk into the mix because there is no free lunch to generate your income stream and you have a reasonable allocation to high yield you want to have a reasonable confidence that most of the significant positions in your portfolio are indeed worth the paper they're printed on, so to speak.
Richard They’re robust enough.
Peter Yes, the high conviction levels in the companies being able to one way or another to redeem that debt. And it's that kind of environment and modelling around stresses that I think will become evermore important in the thinking about constructing portfolios in the future.
Richard So you're able to ignore the vacillations, the noise, as you put it.
Peter I'd love to be able to completely ignore it, but…
Richard Well, you can you stand a little bit above them. But one thing you can't ignore because it's something that is affecting all of us everywhere in the world and Polly referred to it early on is the demographics that are changing - an aging population around the world. Almost everywhere. How does that play out in your world? What concerns you about that side of things?
Peter I don't know if it's necessarily a concern because that would be sort of the silver lining in the cloud for fixed income as an asset class: as populations age and need to have more focus perhaps on capital preservation then they will tend to allocate a little bit more to fixed income. So the risk is, from our perspective, that we can no longer rely upon past history to dictate exactly how cheap fixed income assets can become in the event that growth picks up and inflation picks up because there is such a significant pool of savings that are looking for a desirable income stream, that are willing to commit to additional fixed income exposure at lower and lower levels. So that's one of the dynamics that's currently at play in the market - the buy the dip on the back of the central banks is a short term cyclical thing, but buy the dip on the back of the demographic trends and debt disinflation dynamics in the global economies - that's a more structural thing that we need to contend with.
Richard Much bigger picture.
Peter It's about managing people's expectations too.
Richard And this new reality that we began with, of course. And Polly, I cut you off earlier talking about demographics but what are your thoughts? You’re in a part of the world where China is ageing, other parts of Asia are much younger. How do you adapt?
Polly I think, like I said before, I think investors overall there is increasing demand for income but at the same time I think the one beauty about Asia in particular is that we are just at the beginning - very, very early stage in terms of companies starting to have a consistent dividend payout. So there is still a lot of opportunity. And another example is a lot of developed markets already have REITs but REITs are a relatively new thing. Not that many markets in Asia have REITs set up yet. So that will be an extra investment instrument that we can have from the equity side that can generate decent dividends; stable income. At the same time, if you believe in the overall growth story in Asia asset price appreciation will also benefit the investor as well. So I always tell my investors, if they buy Asian stocks, buying something with an income you get the valuation buffer, you enjoy the long-term growth story in Asia, but you also collect a dividend paycheck every quarter, every six months.
Richard I've got one more question for each of you, a final bit of advice. What should someone consider, what are the opportunities they should watch for at the moment, for those people who are who are looking for income? Chris, let me come to you first.
Chris I would probably talk closer to home really on this one. Linking back to your previous question, just talking about demographics. You mentioned earlier that people are obviously living longer nowadays and requiring a form of income in retirement. We can look across all these asset classes to bring a solution together that can be very targeted in nature. And later in life you're wanting the assurance of your capital going forward, so a more defensive approach, and focusing very much on the downside is a strategy that can sit along perhaps other income solutions in retirement.
Richard Successfully pitching your home turf there. Now let me ask my single asset class managers here what they think the opportunities are. Polly, let's come to you first.
Polly I think opportunities we are facing in Asia: one, another topic that we didn't really touch upon, which is in the spotlight these days is the trade war. A lot of people when they invest in Asia are very scared about the potential negative outcome from the trade war. And that's why, for example, a lot of the tech stock got so down. But as an income fund manager one thing I can tell you, the beauty about Asia is that we have quite a few tech stocks that have very solid balance sheets, some of them even in their cash balance sheet have very good free cash flow. So if you're a long time investor and you believe that this trade war is still going to resolve one way or the other, actually you get a pay, in the form of dividends, to be patient and waiting for that. So I think this is one opportunity that people can look into in Asia.
Richard And Peter, a final word to you.
Peter Two interesting things - one, you mentioned at the beginning was $12 trillion of negative yielding debt, and the second thing that Polly has just left us with was a trade war resolution ultimately coming about. The combination of those two factors is probably the biggest danger for fixed income investors at the moment because once we have the pressure valves released and perhaps so much of this monetary stimulus is no longer required we are going to see perhaps a shift in interest rates. We wouldn't expect that to be your father's shift in interest rates, or mother's shift in interest rates, of 100, 200, 300 basis points but 50 to 100 basis points back up in yields will create some capital loss for investors who are currently getting crowded in. So I think at the moment the sensible thing to do is not only to decrease the duration of the portfolio but the offset to that in order to maintain an enhanced income stream is to diversify and to consider almost a barbell approach of high quality investment grade credits and government bonds if and where you can find them with a positive yield and a positive real yield, namely something like US treasuries, and then adding some high quality emerging markets and high yield credit to the mix. It helps to provide investors with a good risk-adjusted balance in the portfolio.
Richard Ever alert to the dangers. Well thank you Peter Kahn as well as Polly Qwan and Chris Forgan. Now if you want to read more about income investing we have a whole edition for you on the topic online, just search ‘Fidelity Answers’. And if you like this discussion please do rate us on your podcast app. That's it for me. The producer was Seb Morton-Clark and studio management was by a technical army: Connor Baillie and Alex Willcox here in London, and Tommy Su in Hong Kong. Thank-you very much indeed for listening. Goodbye.