Income dilemma

"I am living so far beyond my income that we may almost be said to be living apart" EE Cummings

The challenge of generating income from financial assets has increased dramatically over the last few years. It's an uncomfortable reality for investors who rely on income generated from their portfolios. Adjusting to this new 'normal' has been difficult for many individuals, providing both clients and investment managers with specific challenges.

The financial crisis was an extreme economic dislocation that permeated all levels of society and all industries across the globe. Central banks reacted in a massive and generally coordinated manner by initially slashing interest rates and then undertaking unconventional forms of monetary easing, principally via quantitative easing. The sheer scale of the reaction to the crisis by central banks may have a number of unintended consequences.

However, one intentional impact was to lower returns generated by low risk assets (in some cases guaranteeing losses once inflation and taxes are taken into consideration). This was to encourage savers to deploy their investments into more productive assets that, in turn, would potentially stimulate the economic recovery.

During the ten years preceding the financial crisis (starting on 31 December 2007, for the sake of this blog), the UK ten-year government gilt yielded an average of 4.87 per cent and UK base rates averaged 5.07 per cent. This compares with current yields of 2.4 per cent and 0.5 per cent respectively. These moves have dramatically reduced the return investors can expect to receive from fixed income or cash asset classes.

In effect, central banks are confiscating money from risk-adverse investors by coercing them out of cash deposits and government bonds and into higher risk assets. This has become known as a form of 'financial repression'.

Investors need to face this reality head on and realign their expectations of what income they can sensibly expect from portfolios. Not doing so can result in investors exposing themselves to unintentional risks. This can be all the more serious because the clients with specific yield requirements are often those who cannot afford to take the risk with the capital element of their portfolios.

Investors searching for yield can find themselves shoehorned into an ever decreasing set of assets. The result can be a portfolio concentrated to a narrow set of asset classes, industries, geographies or themes, all of which are apt to become correlated in certain circumstances (such as rising bond yields). Furthermore, the demand for yield is often met by a supply of manufactured or structured products. Some of these may provide an excellent balance of risk and reward, but inevitably there will be inappropriate, illiquid and volatile selections.

It may be that while we are at this point of the economic cycle, investors need to rely more heavily on capital. To many investors, this is an anathema but one that may assist them in navigating the choppy waters of monetary normalisation.

Rupert Elwes is a director at J O Hambro Investment Management

He writes a regular blog on investment for Private Client Adviser

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