How do you construct an income portfolio in a low interest rate environment where investors pile into anything with an attractive yield, driving up asset prices? This is a conundrum Talib Sheikh ponders every day in his capacity as manager of JPM Multi-Asset Income Fund (GB00B4N1ZR98).
"Number one, make sure your portfolio is diversified," he says. "Central bank policy has been very accommodative and risk premia have become more compressed, so people are often taking on much higher levels of risk than they realise. Our solution to this is multi-asset diversification, which will be very important as central banks become much less accommodative. It defies common logic just to be in one asset: as there is uncertainty about the future why not broaden your profile?
"UK investors who focus only on equity income have a lack of diversification and need to look more broadly for assets - even if the dividends they get fall. Over the next three years you should think much more carefully about risk adjusted returns: with the equity market having risen as it has, alarm bells should be ringing."
He argues that you should go for optimal rather than maximum income. "You have to consider how much risk you are taking on for a certain level of yield," he says. "We are prepared to forego yield for capital return, though view the world through an income lens primarily."
He says that you should also think seriously about liquidity risk. "Make sure you are compensated for the risks you do take on," he adds. "Valuations are critical, so thirdly, consider where there is value in the market."
Talib Sheikh CV Talib Sheikh is a senior portfolio manager in JPMorgan Asset Management's global multi-asset group with primary responsibility for managing total return portfolios. He has also managed balanced and tactical asset allocation overlay accounts since 2002. Before this he was an assistant portfolio manager in JPMorgan Asset Management's derivative implementation team and has worked at this company since 1998. Mr Sheikh has a BSc in Agriculture and an MSc in International Marketing from the University of Newcastle, and is a CFA charter holder. |
As to whether bonds or equities will be more important for generating income going forward Mr Sheikh says he doesn't know. “Bonds won't deliver what they have for the last three years and interest rates are likely to go up rather than down - but that is why we run a diversified portfolio," he says. "Interest rates only rise in an environment where the global economy is doing better, and if this happens it will ultimately be good for risk assets, for example, developed markets equities, so we would do well in that environment."
Some investors and analysts think high yield bonds are not worth the risk, but Mr Sheikh and his team are maintaining the fund's relatively large allocation to this - albeit at the lower end of its historical range.
"High yield bonds have become more expensive," he says. "Five years ago they were the buy of a lifetime - very cheap. But we have seen a rally and spreads have come in so we are taking profits on some positions, and our allocation of around 50 per cent has fallen to around 25 per cent. But I'd love a bond re-pricing because it would open up some opportunities to buy more high yield - just now the value is not there."
Mr Sheikh's reasons for maintaining an allocation include a default rate under 1 per cent which he doesn't see increasing because he believes the US economy is by and large recovering. "These assets are not horribly expensive, though also not very cheap," he says. "High yield bonds have a place in income portfolios - it is unlikely the all in yield will fall from here."
He has also added a bit to emerging markets debt - both denominated in hard and local currency. "It gives an attractive yield though we are still underweight and want to move the allocation up to being more neutral," he says.
Finding value
Areas he is not so keen on include investment-grade bonds. "These are massively overvalued and it is crazy to hold them at such valuations," he says. "In the UK the underlying interest rate will start to move up and with corporate bonds which yield under 3 per cent you are not compensated for this risk."
He also believes government debt is expensive.
But he says at individual stock level it is possible to find value. "You have to look hard to find pockets of value but you can find it among European large-cap equities and some emerging markets equities. European equities offer attractive yields plus the price-earnings ratios of the shares we hold are at a discount to the overall level of the market."
Portfolio holdings include gas and electricity company GDF Suez which yields nearly 8 per cent. "This is a high yielder but we are very focused on sustainable yields, and counter holdings like this with European banks and insurance companies with lower dividends that can increase," he explains.
Another example of a high yielder in the portfolio includes UK listed Imperial Tobacco (IMT), while European financial holdings in the portfolio include Italy's Intesa Sanpaolo. After the financial crisis it was one of many eurozone banks which had to suspend dividends to restructure its business and rebuild its balance sheet. "This restructuring process has been carried out very effectively, and ahead of most of its peripheral European banking peer group," explains Mr Sheikh. "This meant earlier this year Intesa was able to commit to re-growing its dividend, and in March, plans were announced to reach a dividend yield of 10 per cent over a period of four years."
Another lower yielder is telecoms company Nokia. "This year, the combined ordinary dividend, special dividend and buy back equate to a return of around 13 per cent, and while this is not fully sustainable moving forwards, we believe the ordinary dividend of 2.5 per cent forecast for next year has scope to be increased - particularly given free cash flow is expected to grow by 27 per cent the following year," explains Mr Sheikh.
Areas he feels are worth paying for include US equities. "Earnings growth should pick up this year and support equities, although the upturn may happen a little later than previously anticipated," he says. "Although US equities are above their historic valuation they are a premium asset class in an economy which is recovering - I am very comfortable paying for them. And I see dividends increasing from these levels."
He particularly likes US preference shares which are usually issued by financial companies. "These offer dividends of around 6 to 7 per cent and are issued by companies in a sector that can benefit as a US recovery takes hold," he says. "We think these are cheap: they have duration but given the recapitalisation of US banks we are comfortable these dividends will be paid."
