By Antoine Lesné, Head of SPDR ETF Strategy & Research, EMEA.

Antoine Lesné, Head of SPDR ETF Strategy & Research EMEA.

Almost a decade after the global financial crisis, unprecedented intervention in financial markets by monetary authorities has had a deeply depressing effect on yields. As we extend into the latter stages of the economic cycle, we also reach a potential cross-road for rates. While inflation has jumped in recent months, it does not appear likely rates will have a major push higher for now; but conversely, the days of ‘lower for longer’ may be behind us. However, reflationary trends could be negative for fixed income, meaning navigating these headwinds would be required.

So where does this leave investors in their search for income?

The evolving nature of bond and equity markets will demand a more nuanced and cautious approach in 2017. In the spring of 2016 we proposed looking for yield in both credit and emerging market debt, along with equities. The song remains the same, and recent moves in yields may offer more attractive entry points.

Three investment ideas for building an income portfolio in a (still) low yield world, include:

1)      Bond indices — option-adjusted spreads
2)      Don’t dismiss emerging market debt
3)      Seek yield sustainability in equities

Idea #1: Corporate bond indices — option-adjusted spreads

Credit markets have been a popular choice for finding fixed income yield. Although corporate spreads are near recent lows, the pick-up in yield remains attractive.

But has the search for yield driven valuations too low, and is it still prudent for yield-seeking investors to focus on corporate bonds? The short answer is that for the first half of 2017, yes — given higher, albeit relatively tepid growth is expected.

In addition, keeping an eye on credit risk is prudent for investors evaluating high yield in this climate.

For example, an investor reviewing the Option-Adjusted Spreads (OAS) of lower-rated sectors could be tempted by the relatively higher yields that CCC-rated bonds offer. However, defaults have moved significantly higher in 2016, and once credit losses are taken into account, these bonds may lose some of their lustre.

On this basis, CCC-rated bonds offer little upside above the potential credit losses and would require defaults to decline substantially in order to prove attractive.

For ETF investors it means doing more due diligence with regards to indices being tracked in the high yield space. In euro high yield, for example, the case of financial subordinated debt has the potential to negatively surprise should bank bail-ins be required. In a year of European elections unfolding against a populist backdrop, an outright bail-out of banks by the government may not be perceived as the best move for the outgoing party in power.

Given the potential for treasury yields to rise further, the excess return credit provides as a buffer over the past few months across indices is attractive.

The bottom line: In this environment, higher-rated high yield credit sectors may offer more attractive compensation for the risk of credit losses at current levels. This approach also provides some cushion if interest rates rise further than anticipated.

Idea #2: Don’t dismiss emerging market debt

Emerging market debt (EMD) recovered strongly in 2016 as concerns around emerging markets (EM) — particularly China — abated. The EMD universe continues to expand steadily, especially in the local currency (LC) space.

But is there a case for EMD LC as a distinct allocation? The long-term case is positive, as the following chart illustrates the attractive yield relative to other fixed income sectors.

Graph: Emerging market debt yield to maturity (%)

EMD LC has historically been a volatile asset class, driven primarily by currency fluctuations, and EMD currencies have weakened steadily over the past few years. Following the sell-off triggered by Trump’s election, EMD currencies provide a more attractive entry point for long-term investors.

Flows in emerging markets have gradually come back since the beginning of the year, and the case for carry in local currency bonds remains for yield-seeking investors. While global institutional flows have been lacklustre in the past months, ETF investors in Europe have come back since 1 January 2017 and invested close to $1.9bn by 9 February in these vehicles — or c. 12% of EMEA-domiciled ETF inflows.

The bottom line: There may be volatility in the short term, but as the market matures we expect to see increased allocations from investors to EMD. And as these countries ‘emerge’, there is a case for a narrowing of the political risk premium between developed and emerging markets in the long term.

Idea #3: Seek yield sustainability in equities

Today’s equity market rally has been characterised by an unusual pattern of sector leadership. Stocks traditionally considered low beta and more defensive have led the rally.

This is particularly true of long-duration sectors where cash flows are more bankable, dividend yield pay-outs high and the risk of a cyclical drawdown in earnings is low. Consumer staples, utilities and health care fit this profile and their valuations have recently fallen back from their over-extension.

On the other hand, more economically sensitive sectors, like financials and technology, the laggards of this equity bull market, have been playing catch-up. From a value investing standpoint, unusually, there appears to be more margin of safety for now in less defensive sectors.

There has also been a significant shift in the dividend pay-out profile across global sectors. The dividend contributions from traditionally more defensive sectors like telecoms and consumer staples have been on the wane, while the dividend contributions of more cyclical sectors, like information technology and energy, are rising.

There looks to be sustainable dividend yields in the resources, telecoms, industrials and information technology sectors. In these areas, valuations and yields in traditional defensive sectors are not compelling, so income investors must employ a more nuanced approach in their search for dividend yield.

Equity investors looking for a long-term income approach would do well to consider investing in an ETF that tracks dividend based indices using a smart beta approach. Particularly where there is a focus on dividend stability and growth. As one might expect, because of the way they screen on dividend, these indices tend to exhibit over-weighting in the industrials and utilities sectors. And despite a bias towards longer-duration assets, these indices have held up relatively well during the recent bond sell-off.

The bottom line: The appearance of high dividends is not necessarily indicative of actual delivery of yield or dividend yield growth. ETF investors need to scrutinise the sustainability of yield. Excessively cyclical sectors will carry some risk of a weakening in earnings power as the economic cycle progresses, with the attendant risk of a cut to dividend pay-out ratios. Investors would do well to prefer strategies that focus on the stability of dividend payment, benefiting from the compounding effect of a more stable yield.