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
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
In this context, Fitch believes that income strategies will be challenged in
four areas: flexibility, discipline, bottom-up research and market risk
- 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
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 -