July 1 (The following statement was released by the rating agency)
Fitch Ratings says that investors should carefully review the investment processes of income funds, to ensure discipline and flexibility is maintained in the search for yield. The recent market volatility also reinforces the importance of mitigating market risks. These key messages have been discussed in Fitch's recent investor roundtable in Paris on 28 May 2013, with panelists from AllianceBernstein, DNCA and Schroders.
Income strategies have been benefiting from positive momentum and two thirds of European managers plan to launch income funds in 2013. Moderate economic growth and sound corporate fundamentals, as well as investors' search for regular income and low volatility, support investments in yield generating assets. At end April 2013, the yield on high dividend stocks was 4% to 5 % on average, 5% in European high yield, 6% in US high yield and 7% in emerging market corporates.
Nevertheless, investors should not overlook that total returns in the recent years were largely driven by capital gains. For example, two thirds of 2012's total return in investment grade indexes came from spread and interest rate compression, and income only accounted for a third.
At this point in the interest rate cycle, investors should not extrapolate recent returns and conversely look at the growing risks, which the recent market volatility confirms. Duration risk is relatively higher at this point in the cycle as only 40 basis points of increase in interest rates offset the yield of typical developed market investment grade indexes. While income strategies tends to focus on 'BBB' and 'BB' corporate issuers, which currently remunerates better than other segments relative to the underlying default risk, fund managers are increasingly looking for yield in 'B' and below rated issuers, where historical default rates increases significantly. Spread volatility is an additional source of risk, notably in high yield where the recent trend until May 2013 can be misleading as the previous 12 month's volatility was only half the level of long term volatility.
In this context, Fitch believes that income strategies will be challenged in four areas: flexibility, discipline, bottom-up research and market risk mitigation.
- Unconstrained processes that can capture yields commensurate with the risk taken and can opportunistically shift from an asset class to another are better positioned. The yield on high yield and high dividend stocks is so close currently that freely shifting from debt to equity can be beneficial to performance. Flexible processes can also lock in geographical yield discrepancies like the 150 basis points extra yield on European credit indices relative to US credit indices in mid-2012. While the gap has now closed at a regional level, there are still yield opportunities at a country level.
- Discipline is also needed to focus on company quality and avoid being dragged down the credit curve as portfolios are reinvested in lower yielding assets. This discipline is also essential in managing expectations of investors who should not view recent returns as repeatable.
- Bottom up research will also increasingly drive selectivity and managers with analytical resources will be better positioned. Since the beginning of 2012, Fitch notes a regular increase of the spread dispersion in European high yield indexes, which highlights the importance of issuer picking.
- Finally, income strategies when deployed in open ended funds cannot escape market risk. Strategies with a focus on low duration bonds and low beta / high quality equity, adequate use of hedging or cash should be relatively better positioned.
The document titled "Income Strategies at this Point in the Cycle", published 1 July is available at www.fitchratings.com.
Link to Fitch Ratings' Report: Income Strategies at This Point in the Cycle - May 2013