By the Cross Asset & ETF Research Team at Lyxor Asset Management.

Quality income: An attractive yield that stands the test of time

The stock markets rose strongly over the first few months of the year, but they’ve been struggling in recent weeks due to a resurgence of the trade war between the US and China. Meanwhile, bond yields are still painfully low. One option for investors to navigate this tricky environment could be to allocate to a quality income equity strategy.

Difficult conditions for investors seeking income

Global economic conditions have been slowly improving since the start of the year and bond yields have sunk even further, with those of European sovereigns now at rock-bottom levels. How might multi-asset investors react in these circumstances?

They have the choice to switch out of bonds into suitable equities or sit tight. Investors who believe that economic conditions aren’t going to improve and that central banks will make ever-more desperate attempts to drive yields lower may decide to carry on holding bonds.

We’re in an environment of low interest rates and low corporate bond yields, and that means there are few safe havens for income seekers. One idea for investors wary of making seismic changes to their asset allocation could be to switch from low-quality bonds into high-quality equities – a change that puts balance sheet strength ahead of anything else.

Why might this be an attractive choice? Taken at face value, the potential income available from high yield bonds looks like it should exceed dividends. But high yield bond indices are made up of the lowest-quality companies in the market, and there’s no guarantee they’ll be able to meet their obligations. These bonds, therefore, have the potential for a lot more risk with little upside.

SG Quality Income Index: Providing an attractive yield that stands the test of time

One option for investors looking to allocate to high-income equities could be the SG Quality Income Index. It’s an equity index that seeks to provide a dependable, high-quality dividend stream. Unlike the MSCI World High Dividend Index, which tends to outperform the broad global markets on a total return basis but struggles in return-only terms, the SG Quality Income Index focuses on corporates that can pay and grow their dividend and aims to maintain its dividend payments regardless of the market backdrop.

By sticking to the same careful, repeatable process, the SG Quality Income Index has been able to avoid more than 80% of the major dividend cuts that have taken place since the global financial crisis in 2007.

Comparison of realized yields for high- and low-quality companies since 1989

Source: Lyxor Asset Management.

In constructing the index, we assess each stock based on three criteria: the quality of its business, the strength of its balance sheet, and the level and sustainability of its dividend yield.

Source: Lyxor Asset Management.

Some important benefits

The high-quality companies that the SG Quality Income Index invests in represent an opportunity to access a less volatile area of the equity market. The nature of these businesses is such that their earnings are predictable rather than cyclical, and this means many investors view them as unfashionable. This can result in these kinds of stocks often becoming undervalued. An extra benefit is that they represent a useful hedge against rising inflation. That’s because the dividends they pay tend to rise in line with prices, unlike fixed-rate securities.

Making money by not losing money

The main reason for the SG Quality Income Index’s outperformance of the broad markets over the long term is the protection from drawdowns it offers in falling markets. For example, during the market stress in Q4 2018, the index outperformed the MSCI World by more than six percentage points. Its volatility (10.6%) was also significantly lower than that of the MSCI World (16.6%) over the last quarter of last year.

As we can see in the following table, high-quality stocks have historically been much less volatile and experienced much lower drawdowns than low-quality stocks.

Buying better quality companies provide your risk control

Source: Lyxor Asset Management.

An attractive option for any kind of investor

If an absolute return investor or multi-asset investor is looking for yield, equity income stocks could look a lot more enticing than sovereign or corporate bonds, which are currently providing historically low yields and offer no protection against inflation.

It’s true that equity income strategies tend to underperform the broad markets when they’re experiencing the kind of irrational exuberance that’s driven them so much higher in recent years. But quality income strategies that value balance sheet strength above all else might be a better option should the markets take another turn for the worse.

And that’s exactly what seems to have been in the minds of European investors this year. European equity income ETFs have received net inflows every month so far in 2019, while broad European equity ETFs have experienced outflows every month.  It seems that now might indeed be a good time to allocate to this kind of strategy.

Net new assets of income generation and broad European equity ETFs in the European ETF market in 2019 (EUR million)

Source: Lyxor Asset Management.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)