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Delivering income in a low yield world

Generating a meaningful level of income within the risk constraints of a retirement portfolio has certainly had its challenges over the last 12 months.

When the full effects of the COVID-19 pandemic hit in March 2020, a number of usually very reliable income sources—such as the banks, REITs, and infrastructure—either reduced, suspended or cancelled their dividends altogether as the global economy came to an abrupt halt. Bond yields, which have been grinding lower for the better part of 30 years, plummeted further, reaching record lows. In fact, yields across an entire diversified portfolio came under enormous pressure and remained that way for the better part of a year.

At Lonsec we were able to generate in excess of the targeted 4.0% p.a. yield (before franking) across our Lonsec Retirement Managed Portfolios despite the difficult market conditions—a great outcome for our clients who rely on this income to fund their retirement needs.

Lonsec’s portfolios have generated income in excess of the 4.0% target (12 months to end March 2021)

So how did we get here?

For us, the single most important factor was active management. Being active at all stages of the investment process—from asset allocation through to manager selection and security selection—was critical in helping deliver income objectives for our clients. With the potential for default rates to skyrocket and dividend traps around every corner, we wanted both our equity and credit managers to really test the balance sheets of companies and ensure the robustness of the businesses we were investing in or lending to.

Wide dispersion in outcomes also played out at the sector level, where the “stay at home” tech sectors, for example, did well out of COVID, while the travel sector was heavily impacted. In an environment where uncertainty is high and there is a large dispersion between the likely winners and losers, active management was key.

Secondly, diversification was, and will remain, very important in terms of how we construct retirement portfolios. COVID-19 has made that excruciatingly clear. If you were relying on the dividends of a few bank stocks to meet your living expenses in retirement, then you took an enormous hit to your income over the last 12 months. We aim to diversify income sources broadly across not only asset classes – but also across the underlying drivers of that income—whether that be dividends from equities, option premia, bond coupons, rental income from real estate and other sources.

Over the course of the year, we also broadened out the types and sources of income we were accessing in the portfolio. We invested in relative value strategies in the fixed income space that didn’t rely on credit or duration to generate returns as well as shorter duration credit strategies that had the ability to rotate across fixed income sectors to source income.

We also accessed some more idiosyncratic or alternative sources of income (via multi-asset income strategies), which allowed us to gain exposure to assets such as litigation finance, catastrophe bonds, healthcare and music royalties. Importantly, these additional sources of income were largely unrelated to what was going on in the broader economy and uncorrelated to existing income sources in the portfolio.

Crisis equals opportunity

It is often in times of crisis that the best opportunities emerge. We believe it is important to be opportunistic and have enough nimbleness in your process to take advantage of those opportunities as they arise. Shortly after the market sell-off in March 2020, good opportunities opened up in some of the higher yielding credit markets as spreads blew out. We entered a position in syndicated loans given the spread widening in that sector, funded by reducing our exposure to a traditional global equity dividend yield strategy which was facing headwinds from the COVID-induced shutdown.

We also tilted towards strategies where there was an obvious tailwind. For example, we increased our weighting to strategies employing option strategies which we felt were well positioned to take advantage of the increased volatility in markets. Key to being able to take advantage of these opportunities is having a robust decision-making framework in place that allows you to respond quickly.

Looking forward now, and with the worst effects of the COVID-19 shutdown largely behind us, we have adopted what we would consider to be a more ‘normal’ portfolio position in that we are now close to benchmark weights across the major asset classes. Yields have begun to normalise, not only in equities where companies are feeling more confident about paying distributions, but also in bond markets where higher bond yields underpin our more optimistic outlook for income across the remainder of the year.

Author: Deanne Baker

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