Go with the cash flow
Income funds predominate in a risk-averse, yield-seeking era. Jeanny Yu examines how such funds are built
Income funds have been the popular choice of many retirees and working adults looking for a stable wealth builder over time.
Income funds designed to provide steady income. The aim is for stable yield, as opposed to big capital gains that you might get with growth stocks. Income funds as such make heavy use of bonds and other fixed-income instruments, and high-dividend stocks.
These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors.
As such, the audience for these funds consists of conservative investors and retirees.
As post-war baby-boomers approach retirement age, Hong Kong's own retiree population is set to surge from about 900,000 now to 2.1 million by 2030, accounting for a quarter of the population, according to a government report released in May.
The ageing population is driving appetite for higher income over the long term.
Yet such funds, which seek steady cash flow on a regular basis for conservative investors, are struggling to achieve target yield and forced to take more risks.
"To get that increase of yield, investors have to take some risk. That could mean investors looking more broadly towards opportunities in Asia to get some additional yield pick-up," says Gregor Carle, investment director for the fixed-income team at Fidelity Worldwide Investment.
Government bonds in developed markets have been traditional sources for the income fund, yet fund managers are seeing yields from those "safe-haven" government bond yields sitting at record low levels.
As a result, low-income yield is causing trouble for income fund managers in meeting return targets.
According to a survey conducted by Greenwich Associates in June, up to 65 per cent of Asia institutional investors reported a decline in income yield. Average income yield for Asian institutions for the past five years stood at 5 per cent, falling short of the required 5.2 per cent on average.
Falling treasury yields are forcing investors to hunt for new income generators. "Investors have become more interested in less mainstream, higher-yielding bond asset classes.
Looking ahead, with bond yields so low, the scope to earn the same levels of income as before has lessened. As a result, investors have become very keen on looking for more yield from their portfolios.
This pattern is a global theme, including among investors in Hong Kong," said Dominic Pegler, managing director, senior product strategist at BlackRock Asia-Pacific fixed-income team.
In 2008, government bonds were the only instrument that saw positive returns, standing at 9.26 per cent, compared with a negative 26.63 per cent on average for high-yield bonds and 4.84 per cent loss for investment grade bonds. Yet the situation has changed after escalating fears about the European debt crisis sent investors rushing to safe-haven investments, causing a slump in bond yields.
In the first five months this year, government bond returns stood on average as low as 2.64 per cent, compared with 6.03 per cent for high-yield bonds and 4.57 per cent for investment grade bonds, according to a Fidelity report.
"As long as we are in this low-interest rate environment, investors are going to continue to struggle to meet some of those return requirements," Fidelity's Carle said.
As bond yields have fallen, investors are now becoming more interested in products that are less mainstream, such as so-called "junk bonds" and dividend-paying equities.
"Investment grade [bonds] probably offer more attractive risk-adjusted return, at this point" Carle said. "Nevertheless, high-yield bonds still enjoy a lot of interest from investors as fundamentals in the corporate space still remain pretty supportive."
According to the Greenwich survey, investment grade bonds, those municipal or corporate bonds rated above BBB at S&P and Baa at Moody's, in developed and emerging markets, will be the most popular area for income funds to search for income.
Meanwhile, analysts are looking at the dividend-paying equities, with equity dividend yields being well above the 15-year average.
"Dividend yields on regional equities, especially those high-quality equities, are currently robust, making stocks a powerful tool for generating income and for growing assets, while cheap valuations offer an attractive entry point," BlackRock's Pegler said.
"We see the best yields available in developed equity markets and selected Asian stock markets," says Dave Fishwick, head of macro and equities investment at M&G Investments, when asked what would be the most favoured asset in the next five years.
With income fund mangers becoming bolder in search of yield, however, investors are warning of risks.
"There is a higher liquidity risk in high-yield bonds but there is more interest rate risk in investment grade bonds, as they usually have a longer duration," Carle said. "It is not just about yield. You can not just look at the return, you have to look at the risk as well."
BlackRock's Pegler added: "While some equity markets are well placed to play this role, care should be taken to make sure that equity holdings are part of a diversified income-generating portfolio … and that an investor's investment horizon is sufficiently long enough to maximise the benefits of holding equities."