The case for income This document is for Professional Clients only and is not for consumer use. Income-seeking investors have faced headwinds in the aftermath of the global financial crisis. Interest rates have been trapped at historic lows for many years now, resulting in savers receiving a pitiful rate of return. Likewise, yields gained from bonds are near record lows, and the current market environment also provides an additional challenge to those who may wish to hold bonds for income: interest rates are likely to go only one way from here. Should interest rates indeed rise, bond holders could see their capital diminish. This comes at a time when demand for income has been rising. A large proportion of the UK population, ranging from individuals to firms and institutions, requires income in one form or another. This has been accentuated by a recent demographic transition, which has seen the Baby Boomer generation edge towards retirement age. At the same time, a change in UK regulations introduced in April 2015 gave people greater access to their pensions, presenting new choices in how to manage their money. One solution to meeting these investment needs is the ability to generate a reasonable income without embedding excessive capital risk within a portfolio. Here, we will discuss elements of one approach to multi-asset investing, which focuses on delivering a consistent level of income while aiming to preserve capital through time. Challenging investor assumptions: past performance is not necessarily a guide to future returns Investors typically seek varying degrees of growth, income and risk from their investments. But what if their preconceived ideas of how to deliver on these three measures is challenged? What if their method for achieving them all at the same time is not entirely aligned with what was delivered in the past, or what can be delivered in the future as market conditions change over time? Let us take a look at an investor with a simple asset allocation model, whereby the portfolio s growth asset is defined as equities and the income asset defined as bonds. In this case, the relationship between the two asset classes clearly matters. The investor s portfolio would likely suffer if equity markets experienced a fall that was not accompanied by the corresponding cushioning from bond markets. This type of portfolio could also fail to deliver, should the desired level of real (inflation-adjusted) income not be achievable through the income assets available. There are many challenges an investor can face in trying to deliver a blend of capital growth and income whilst also diversifying risk. Let us view each of these elements in turn. 1. Capital growth As shown in Figure 1, only US equities (and Japanese equities by a margin) have achieved a total return in excess of cash 1 +5% over the past 10 years. Cash +5% has typically represented the equity risk premium the level of return required to compensate investors for taking on the relatively higher risk of equity investing compared to the risk-free rate. Figure 1 10-year equity market returns 08 S&P 500 index FTSE 100 index Euro Stoxx 50 index Hang Send index 10 12 Nikkei 225 index MSCI Asia ex Japan index 3-month LIBOR + 5% 14 16 300 250 200 150 100 50 Georgina Taylor and Sebastian Mackay Fund Managers, Multi Asset Source: Bloomberg as at 31 May 2018.
2. Income As shown in Figure 2, neither bonds nor equities have consistently delivered an income above UK cash rates over the past 30 years, which puts real income levels under pressure. Figure 2 Income generated from equities and bonds have been inconsistent % of time since 1980 that yields have been greater than UK 3-month interest rates UK 10-year Government bonds US 10-year Government bonds FTSE All Share MSCI World (%) 70 60 50 40 30 20 10 % of time since 1980 Source: Datastream as at 30 April 2018. 3. Diversification Bonds and equities are not always negatively correlated, which means that falls in equity markets are not always offset by an increase in bond values. Figure 3 shows the rolling one-year correlation between US equity prices and US 10-year bond prices and shows that, for periods of time, the two asset classes become positively correlated. This potentially dilutes the amount of diversification embedded within a multi-asset portfolio, and argues for a more flexible approach to multi-asset investing. Put differently, during these periods of positive correlation, the amount of risk embedded within a portfolio increases. Figure 3 Correlation between equities and bonds 1-year rolling correlation of total returns: MSCI World vs 10-year US bonds 1983 1987 1991 1995 1999 2003 2007 2011 2015 (%) 80 60 40 20 0-20 -40-60 -80 Source: Datastream as at 30 April 2018. The challenges investors face in trying to achieve capital growth, income and diversification underpin why an alternative income strategy can play an important role within a portfolio. Should investors be targeting a desired level of income, but also care about the level of capital preservation and growth across their portfolios, multi-asset income may help deliver on that investment aim. 02 The case for income
Why is capital preservation important? Another consideration when looking at income options for a portfolio is to ensure capital is preserved so it can grow. There are several reasons why capital can be eroded, but chief among them are: (1) excessive risk-taking in the hunt for yield and (2) units are redeemed to generate income, which could deplete capital through time. 1. Excessive risk-taking in the hunt for yield We believe a pure focus on income can lead to excessive risk-taking. Figure 4 shows that the highest yielding assets globally are also the higher risk areas of fixed income. To achieve average cash rates relative to history, an investor would need to look at high yield corporate bonds just to match the income generated from a bank account in the past. Figure 4 Higher yield typically means higher risk Yield as of 31 March 2018 Average yield since 1998 Target yield of the fund* Average 3-month LIBOR since 1998 UK 3-month LIBOR UK 10 year Gilts UK BBB corporate bonds Euro high yield corporate bonds US high yield corporate bonds 10 8 6 4 2 * Fund = Invesco Perpetual Global Targeted Income Fund. Source: Bloomberg as at 31 March 2018. Investors can incorporate yield (income) into their portfolios through both liquid investments and illiquid investments. Illiquid investments such as private equity and physical property do, in a number of cases, provide attractive yields. However, the obvious trade-off is the lack of liquidity should the investors need to access their capital. Within the liquid universe there are several options but, typically, fixed income and high dividend equities are used. Historically, these are very important components of the income element of a portfolio. However, they do not come without capital risk. Longonly equity and bond funds, for example, may deliver income to investors for a period of time, but are at risk of losing substantial amounts of capital during periods of market stress. As discussed earlier, bonds and equities are not always negatively correlated, which means that falls in equity markets are not always offset by a rise in bond values. Figure 5 shows the correlation between some of the income-oriented Investment Association (IA) sectors. The blue bars show the correlation between the IA Global equity income sector and each of the other four income sectors since 1998. Over the long term, there is some diversification between income oriented sectors. However, the correlation is not stable. For example, the pink bar shows the correlation during a time of market stress, namely the taper tantrum in 2013 when equities and bonds became positively correlated. The purple bars show the correlation between the sectors yearto-date. As bonds have come under pressure this year, equities have struggled, which means both equity income and bond funds have become increasingly correlated. Consequently, this could mean that there is more capital risk embedded in the income component of a portfolio relative to investor expectation, which could lead to capital erosion over time. 03 The case for income
Figure 5 Correlation between income-oriented fund sectors Since 1998 2013 Taper Tantrum (H2 2013) 2018 to-date IA UK Equity & Bond Income NR IA Strategic Bond NR IA Global Bonds NR IA Corporate Bond NR (%) 100 80 60 40 20 0 Source: Lipper as at 30 April 2018. Correlation with the IA Global Equity Income sector 2. Units are redeemed to generate income, which could deplete capital through time If an investor requires income, it is generally better to buy an income fund rather than cancel units in a growth fund, the reason being it avoids any market or fund timing issues. If a multi-asset growth and income fund performs in line with their target, there will be no difference between cancelling units and receiving income from the fund directly. However, if both funds experience a short term set back, ring-fencing the income is important to fully participate in any subsequent rebound. Figure 6 illustrates this point; it shows the total return from a drawdown strategy and an income strategy, if both suffered a series of 2% declines over three consecutive months (between March and e). Figure 6 Total return from a drawdown strategy and an income strategy Income plus capital preservation Drawdown strategy Dec Feb Mar Apr May Jul Aug Sep Oct Nov Dec 102 100 98 96 94 92 Change in underlying capital Source: Invesco. For illustrative purposes only. If units were redeemed each month during the market fall, the client s total return would have been impacted. Figure 7 shows the difference between the two lines (from Figure 6) over the subsequent months. The income strategy participates more in the upside because no units have been cancelled and therefore capital has not been depleted. Conversely, because units on the drawdown strategy have been cancelled, the client has less capital invested and cannot participate as fully in the upside. 04 The case for income
Figure 7 Total return differences between a drawdown strategy and an income strategy Feb Mar Apr May Jul Aug Sep Oct Nov Dec 2.0 1.5 1.0 0.5 Difference in total return (% points) Drawdown of 5% in April, May, e, 5% rebound in July, August and September. Source: Invesco. For illustrative purposes only. How do we solve these problems? We have now reviewed the need for income, capital preservation and diversification, but how do we solve the problems associated with delivering all three to investors? We believe we can do this through our Invesco Perpetual Global Targeted Income Fund a multi-asset income fund that utilises all asset types and does not rely on an asset allocation model. We view the world a different way: We break away from traditional asset allocation and are unconstrained by asset type and geography We have maximum flexibility to generate income without the need to take increased risk We blend ideas to aim to achieve a targeted income with the aim of preserving capital in a risk-managed, diversified portfolio Figure 8 Investing in ideas Total independent risk Portfolio risk Target income The fund aims to deliver a gross income of UK 3-month LIBOR +3.5% 2 p.a. whilst seeking to preserve capital 3 over a rolling three-year period 4 Target volatility Less than half global equity 5 volatility p.a. over a rolling, three-year period 4 A blend of income and capital ideas Diversification benefit Portfolio Typically, 20-30 individual investment ideas across asset classes with a time horizon of two to three years Investment philosophy Unconstrained research combined with a robust, risk-based fund management process Source: For illustrative purposes only. 05 The case for income
Decomposing total return An individual s total return is a combination of their income and capital growth. For the purpose of an income fund, separating them is very important because in the UK an income fund cannot pay income out of capital. Therefore, only returns which have been defined (from an accounting perspective) as income can be distributed. Income Total return Capital The capital side of the equation is as important as the income component because we want to preserve capital for investors over rolling, three-year periods, after fees. Therefore, it is very important that we consider not only the overall income generation across the portfolio, but also the potential for capital growth. It is crucial for us to ensure that we do not sacrifice capital for enhanced portfolio income. That is the reason why not every idea within our fund is designed to generate an income. As at the end of April 2018, around two thirds of the ideas within the portfolio were income-generating ideas, whilst the remaining third were designed to aid capital growth. The risk profile of ideas is an important part of this thought process, as none of them should be able to change the overall risk profile of the fund. We discuss more detail behind our approach and some idea examples below. Achieving our two explicit targets There are two important elements to running a multi-asset income strategy: 1. A flexible investment universe 2. An equal emphasis on income generation and risk management Both of these elements play a part in two distinct stages of our investment process. The first step of our investment process is research. When we search for investment ideas, we are free to roam across asset types, in order to find opportunities we believe can deliver a positive total return over the next two to three years. Step two focuses on which investments we should combine into a single portfolio that would deliver a specified level of income, capital preservation and a target level of risk. Only ideas that have passed the first step in the investment process can be selected for inclusion into our strategy, and consequently, each of the selected ideas must have the ability to deliver a positive total return over the next two to three years. Therefore, we do not invest in anything for the sole purpose of boosting income or increasing the diversification our portfolio. Investing in ideas A repeatable three-step process Step 1 Research Thematic T Economic E Analytic A Managers M Step 2 Fund Management Approving ideas Risk Scenarios Structure Liquidity Step 3 Implementation Combining ideas Order Comply Execute Review Implementing ideas Portfolio review and oversight 06 The case for income
We will now examine two investment ideas held within our portfolio to illustrate how our investment process works in practice. Interest rates Australia vs US This idea was included in our fund at launch and held up until April 2018. It is an interesting example of a relative value fixed income idea, which behaved differently to a long-only fixed income investment, and yet it provided an attractive level of income due to the implementation route chosen. The idea itself was based on the belief that bond yields in Australia and the US would converge. We believed that the interest rate hikes being priced into Australian fixed income markets were excessive relative to the actual economic outturn. In contrast, we believed the Federal Reserve would continue to gradually raise interest rates against a steadily improving US economic backdrop, which would underpin higher US bond yields, particularly relative to Australia. Figure 9 shows that the 10-year interest rate swaps of both countries have now converged, with the US 10-year swap rates now marginally above Australia. Figure 9 US and Australian 10-year interest rate swaps have converged Australia US Dec 16 Feb Apr Aug Oct Dec Feb 18 Apr 18 3.5 3.0 2.5 2.0 10-year interest rate swap Source: Bloomberg as at 30 April 2018. This idea has been useful for the Invesco Perpetual Global Targeted Income Fund for three reasons: 1. The idea has contributed positively as interest rates have converged 2. It provided approximately 9bp of income for the portfolio whilst in the fund 3. It is risk neutral for the portfolio the risk model calculates its correlation to equities as zero. The more technical aspect of the idea is its implementation. The plain vanilla implementation route would be to either buy and sell the underlying bonds, or buy and sell the bonds via interest rate swaps using the derivatives markets. One of the reasons we use derivatives is so that we are not tying up capital by using cash to invest in each individual idea. This helps us manage the portfolio more efficiently. Therefore, if we were to use the swaps markets the calculation of the income would be as follows: Option 1: Buy an Australian interest rate swap versus selling a US interest rate swap. When buying an interest rate swap an investor receives the difference between the fixed interest rate, which they are receiving, less the floating interest rate which they are paying. We will define this return as the net interest payment from the interest rate swap. If we utilised this implementation route we would receive the net interest payment from the Australian interest rate swap and pay the net interest payment from the US interest rate swap. At the time of implementation in November 2016, the difference between these two was close to zero. This is the income embedded within the investment idea. It is close to zero because although we are receiving the Australian net interest rate, we are paying the US net interest rate at the same time. This reduces the income embedded in the idea. 07 The case for income
Option 2: Because of the different treatment of income for an income portfolio we can increase the contribution to our income target by using interest rate swaps in a different way. If we still buy the Australian swap but sell a forward start interest rate swap for the US then we increase the income available to us because we are not paying away the net interest payment on the US leg of the investment idea. This takes the annual income received through the idea to just over 1%. The idea s contribution to capital preservation is as important as its contribution to income. During the equity market fall and indeed the fixed income market fall this year, the idea held up very well. Figure 10 Performance of the Interest Rates Australia vs US idea during a market fall Q1 2018 MSCI World US 10-year Treasuries Australia vs US 10-year bonds 6.0 4.0 2.0 0.0-2.0 Source: Datastream as at 31 March 2018. Currency Indian Rupee vs Taiwanese Dollar Currencies can be a great hunting ground for an income portfolio but investment intention for currency ideas matters. There are two ways to generate return from a currency idea: currency appreciation or interest rate differentials (or carry). For an income fund, these two return profiles impact whether the returns from the idea can be streamed to the either the income or capital account, and determines what can be distributed to clients. Our Currency Indian Rupee vs Taiwanese Dollar idea is an example of a carry idea because there is an attractive interest rate differential between the two currencies. In India, the cash interest rate as of e 2018 is 6.25% whereas in Taiwan it is only 1.38%. Therefore, if an investor held Indian rupees they can effectively earn over 6% on that cash but a cash holding in Taiwanese dollars would only return just over 1%. The difference between these two interest rates is the carry available on the idea if an investor sells Taiwanese dollars to buy Indian rupees. Figure 11 Interest rates in India and Taiwan India policy interest rate Taiwan policy interest rate 11 12 13 14 15 16 18 9 6 3 Source: Bloomberg as at 7 e 2018. 08 The case for income
As with the Australia versus US interest rate idea, this idea is also useful from a risk management perspective. Figure 12 shows the correlation of the idea with equities and bonds. The attractive element of the India versus Taiwan currency idea is that it has zero correlation with either bonds or equities over the longer term, which means it is a good idea to add to a multi-asset fund in order to reduce the directionality within the portfolio. Figure 12 Correlation of the India vs Taiwan idea with equities and bonds Correlation from Market Currency pair the end of 2014 MSCI World index INR/TWD -7% US 10-year treasuries INR/TWD 3% Source: Bloomberg as at 30 April 2018. The differences between a multi-asset growth fund and a multi-asset income fund The main difference between a multi-asset growth fund and a multi-asset income fund lies in how the income component of the total return is managed. An income fund generally distributes a monthly income to clients. With our fund, we aim to smooth that distribution so that clients receive a relatively similar amount each month throughout the year. Each month, Invesco s Income Distribution Committee makes a decision on the fund s payout for that month. On a daily basis, our team also monitor the income available to pay out to clients, making sure this is on track given any changes, or potential changes, in the LIBOR interest rate, which may affect our gross income target of UK 3-month LIBOR plus 3.5%. We can also reduce the income across the fund, if we are running well ahead of target by changing the implementation of an idea, so that it contributes to the capital component of the total return calculation rather than income. Income can be extracted from ideas in different ways, as illustrated in our examples above. Another source of income for a multi-asset income portfolio is to use the derivatives markets by selling put and call options. It is a technique we can utilise, but we do not systematically sell call options against our equity positions in order to generate an income. If we were to do this, we would be reducing our ability to participate in the upward move beyond the market level we sell the options at. Figure 13 illustrates this point: should we sell 10% out-of-the-money call options, we would not benefit from market moves above 10%, because the buyer of the options will exercise them. Figure 13 Selling out-of-the-money call option results in a ceiling Long UK equity position Long UK equity position + selling 10% out of the money call options 6900 7100 7300 7500 7700 7900 8100 8300 8500 8700 8900 9100 9300 25 20 15 10 5 0-5 -10 For illustrative purposes only. For us to include options overwriting (selling call options) within the portfolio, it would have to be approved as an investment idea and the potential loss of participation in market moves would also have to be considered during the decision-making process. 09 The case for income
How multi-asset income strategies can be used within a portfolio At the core of a portfolio A multi-asset income fund can sit at the core of the portfolio, providing the client with income whilst also potentially preserving capital. Satellite holdings may be introduced, should the client have other peripheral needs. Satellite Multi asset income Satellite Satellite As an income generator A multi-asset income fund can complement other incomegenerating assets within the income portion of a broader portfolio. As they typically do not have too high a correlation with either equities or bonds over the long term, a multi-asset income fund can hence enhance diversification, which is key to managing volatility, while also potentially delivering a consistent level of income to investors. Growth Income other Multi asset income As a volatility dampener Due to their low correlation to equities or bonds over the long term, a multi-asset income fund can be a useful tool for managing volatility. Multi asset Core Alts Diversifiers 10 The case for income
Conclusion Demand for income has been increasing and, with traditional income routes facing headwinds, investors may need to cast their nets wider. Some may believe that buying growth funds and selling units as income as needed may be sufficient. However, doing so leaves the investor exposed to market and fund timing issues. We believe that a multi-asset income strategy can fill the need for income, whilst also playing an important part in a broader portfolio. The potential combination of stable income and capital preservation allows a multi-asset income fund to bridge the gap between the capital growth and income components of a portfolio. It can be added to the income component as a standalone solution or can happily sit alongside fixed income and equity income funds to provide more diversification. In our view, the key to a successful multi-asset income strategy is to place equal emphasis on its three targets: income generation, capital preservation and risk management. We believe that an overemphasis on income generation can lead to excessive risk taking, particularly in the current environment, and therefore a combined approach is optimal. A multi-asset income fund can utilise various techniques for generating income. Finding the most effective way to use an instrument is crucial, but understanding the characteristics that each implementation route provides is just as important for portfolio construction. This is because one implementation route may be more beneficial than another, in order to generate accounting income that can be ring-fenced and distributed to clients. This is what sets a multi-asset income fund apart from a multi-asset growth fund implementation matters more. 1 Cash is defined as 3-month LIBOR. 2 Before deduction of corporate tax. 3 Net of fees. 4 We cannot guarantee that the fund will achieve its income or capital preservation goals; your clients could get back more or less than the target income and they may not get back the amount they invest. 5 MSCI World. 11 The case for income
Investment Risks The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested. The fund makes significant use of financial derivatives (complex instruments) which will result in the fund being leveraged and may result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment. The fund may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss. This counterparty risk is reduced by the Manager, through the use of collateral management. The securities that the fund invests in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity for the securities in which the Fund invests, may mean that the Fund may not be able to sell those securities at their true value. These risks increase where the Fund invests in high yield or lower credit quality bonds and where we use derivatives. As one of the key objectives of the fund is to provide income, the ongoing charge is taken from capital rather than income. This can erode capital and reduce the potential for capital growth. Important Information This document is for Professional Clients only and is not for consumer use. All data is as at 30.04.2018 and sourced from Invesco Perpetual unless otherwise stated. Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities. For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the Annual or Interim Reports and the Prospectus, which are available using the contact details shown. Invesco Perpetual is a business name of Invesco Fund Managers Limited Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK Authorised and regulated by the Financial Conduct Authority EMEA4508/63804/PDF/260618