The scarcity of income: A 'Hobson's choice'

Thomas Hobson
Thomas Hobson (1544–1631) was the owner of a large number of horses held out for hire. When customers sought to hire their pick, they were always offered the next one in line in the stall. The others, while attractive, were not ever an option for hire. Customers only ever had one choice to execute their needs for reliable transportation.

Upending the asset classes of the world in search of income has led to a dilemma. Should one pursue rock-bottom-yielding, “risk free” sovereign debt? Or have developed market monetary policies left little alternative but for investors to seek higher income-paying “riskier” assets?

In reality, one could make the case that there is no true dilemma, but rather a Hobson's choice.

Thomas Hobson (1544–1631) was the owner of a large number of horses held out for hire. When customers sought to hire their pick, they were always offered the next one in line in the stall. The others, while attractive, were not ever an option for hire. Customers only ever had one choice to execute their needs for reliable transportation.

For income, does one tilt an asset allocation toward lower-yielding sovereign or other similar bond assets in an improving economic environment with a potential for rising yields (and falling bond prices), or toward more “risky” assets (such as dividend-paying stocks and non-investment-grade bonds) in an environment of improving credit quality?

As usual, most investors are facing this question with it framed squarely in the rear view mirror of their logic, based on the history of the global financial crisis, rather than the prospect for more normal times ahead.

The problem with the status quo — remaining weighted toward fixed income, low-yield investments — is three-fold. These securities are providing very little income for investors. If and when interest rates eventually rise, the value of these investments will fall. Finally, if and when inflation rises, the real yield on these securities might become even less attractive. Once an inflation impact is figured into the equation, these “relatively safe” fixed-income instruments don't look as attractive. Inflation-linked bonds do offer investors a hedge against inflation. However, TIPS yields recently have been negative.

The search for income-producing assets might not be just a theme for 2012, but a characteristic of a demographic shift to an older population in many developed economies and some emerging ones.

A search for yield in riskier asset classes during low-yield environments often is driven by two factors. First, lower yields have historically occurred at a time of accommodative monetary and fiscal policy, where central banks and governments are attempting to boost economic growth. Equity markets tend to rally in anticipation of the ensuing economic recoveries. Second, when yields on low-risk securities have fallen, investors' risk appetite tends to increase — they are willing to assume more risk in pursuit of higher returns, often based on simply having few options.

Several income-producing assets that might see increased investor demand (and, if so, perhaps higher future pricing) are dividend-paying common stocks, high-yield bonds, leveraged loans, collateralized loan obligation equity tranches (that's right, they're back), convertible bonds, REITs, master limited partnerships and certain types of private equity investments.

The spread between the dividend yield of utilities and 10-year U.S. Treasury yields is at recent highs. For MLPs, the current spread was only recently surpassed during the 2008 crisis.

The broader equity markets also are attractive on the basis of yield spreads relative to historical data.

Current stock valuations are attractive given company fundamentals. Margins are at all-time highs, while the price-earnings ratio is at its lowest point since 1990. Taken together, the ratio of P/E to margins is near all-time lows, suggesting an attractive entry point into the equity market.

Slow economic growth in Europe might restrain U.S. profit growth in the near-term. Periodic dips in U.S. margins might occur, based on price increases in commodities such as energy and agriculture. We do not anticipate these issues to have a lasting impact on margins. Potential wage increases would present a bigger risk for margin contraction while also signaling a boost in overall economic growth. Moderate wage-based inflation can be beneficial for corporate profits, to the extent that it stimulates overall consumption or provides companies with pricing power as a result of rising costs. This historically has been associated with P/E multiple expansion.

While S&P 500 profit margins are high, corresponding dividend payout ratios are low. Companies have been reluctant to increase dividends dramatically in the face of economic uncertainty. With economic growth showing signs of improvement (our base case scenario), we anticipate that dividends have the potential to increase. As companies feel more comfortable about the recovery, they might do some combination of putting cash to work productively in capital expenditures and returning it to shareholders. However, one concern about the future growth rate for corporate dividends would be the prospect for materially higher income tax rates applied to U.S. dividends.

There is an environment of improving credit quality for high-yield bond issuers in the U.S., thanks to healthy corporate balance sheets and generally solid profits. U.S. non-investment-grade issuers generally appear to be adequately capitalized with sufficient cash flow and recent debt maturity extensions to help U.S. default rates remain low. In an improving economic environment, we would expect credit spreads to remain low. This scenario makes high yield and leveraged loans potentially attractive yield asset classes for investors in 2012.

Convertible bonds also offer a form of income with optionality. Although the income level is not variable, improvement in the equity or credit profile of the issuer can offer the potential for additional returns.

Additional potentially attractive opportunities can be found in CLO junior debt and equity tranches. Although CLOs were a notable place of particular pain post-2008, today's CLO market fundamentals are recovering and may remain constructive.

CLO equity performance is ultimately driven by the performance of the underlying non-investment-grade loans, the fundamentals of which are currently improving. CLO deal terms are more attractive now than was the case for deals done before the 2008 crisis. It is likely that investors still have “cold feet” about CLOs because of recent experiences, thus leading the market to be less efficient and potentially under pricing CLOs. This might provide increased opportunity in the form of higher return potential in the near-term.

Private equity includes an array of strategies that seek to take advantage of the current environment for yield. One such area is mezzanine debt, which, by virtue of coupling an interest component with equity participation, can provide an attractive combination of fixed income-like cash flows and equity-like upside.

In addition, unique niche strategies are available to take advantage of specific income opportunities, such as funds focused on drug royalty cash flow streams that seek to generate equity-like returns that are remitted mostly through income and tend to be uncorrelated with equity markets.

The post-global financial crisis environment has resulted in rock-bottom yields for U.S. Treasuries and other sovereign debt deemed to be either liquid or low risk. This situation leaves income seekers in some markets with a negative real yield (inflation-adjusted), which could become more manifest during periods of rising interest rates in eventually recovering global economies.

These investors might want to consider migrating a portion of their asset allocation to less senior income-producing securities. While high-dividend equities, high-yield fixed income, REITs, MLPs, CLO equity, leveraged loans, convertible bonds and income-oriented strategies in private equity have different risk/return profiles, they generally offer an opportunity for escalating income or credit spread tightening. There is a case to be made for the current attractiveness of these asset types, especially relative to the alternative of purchasing low income-paying, more senior securities.

Historically, there might have been less attention placed on the receipt of variable income from securities purchased by some investors primarily for capital appreciation.

However, in a low interest rate environment, and potentially an environment of low returns for asset classes generally, we think the total return benefit from the receipt of income should not be overlooked. For example, in 2011, the price-only return on the S&P 500 was approximately 0%. However, when dividends were added, the total return for this index was 2%.

The importance of counting pennies was reflected in a verse underneath an early engraving of Thomas Hobson, in which he was depicted holding a sack of coins. “Witnes the Bagg he wear's (though seeming poore)...Then laugh at them that spend, not them that gather.”

Alan H. Dorsey, CFA, Managing Director of Neuberger Berman, is the Head of Investment Strategy & Risk, Chairman of the firm's Investment Risk Committee, and a member of the firm's Asset Allocation and Operating Committees. Leah Modigliani, Senior Vice President, is a Multi-Asset Class Strategist on the Investment Strategy and Risk team. Juliana Hadas, CFA, is Senior Vice President, as part of the Investment Strategy and Risk Group.