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Chasing Income, the duration risk21 July 2016

With the help of Britain’s vote to leave the EU, there is now almost $10 trillion invested in Global Bonds which have negative yields. This has given rise to duration risk (sensitivity to changing interest rates) growing fast across the world, and many believe it is one of the main risks threatening fixed-income portfolios. Investors have been forced to buy longer dated bonds to maintain the levels of return required, however, the danger here is when interest rates rise.

In the bond market, prices have risen and yields fallen, which leaves investors searching for income with no other option but to buy weaker credits or buy longer dated bonds. However, the high risk doesn’t come with higher return. In fact the risk-return trade-off is getting worse. Added to this the Bank of England is struggling to buy bonds, in its recent round of quantitative easing pension funds and insurance companies did not want to sell as they would not be able to buy bonds generating the same income today. Pension fund liability matching rules mean that as yields fall pension funds need to purchase more bonds to maintain their income generation, and hence are currently buyers rather than sellers of bonds.

One solution to chasing income is to change asset class from fixed-interest to equity. The risk, although historically higher, moving from fixed-interest to equity is in fact, currently, an equal trade off, with the risk in the equity market being similar to the duration risk investors are willing to take to achieve some yield.

Equity income funds are the perfect solution to the income dilemma. Particularly when you look at sectors such as UK healthcare and UK financials whose dividend cover has increased in the past twelve months. Adding to this the referendum vote which is tipped to favour UK companies with large overseas operations or big export margins. Equity income managers will typically have a significant exposure to those sectors. Having said this, income paying stocks should be considered within the global market and not just UK Equity Income. Funds such as Blackrock Continental European Income boasts holding stocks which over the past 5 years have never cut their dividends and therefore the fund has produced a steady, assured income for its investors. This is reflected in the funds net yield of 3.9% in 2016 which is achieved with significantly less volatility than the benchmark. Selected European equities offer yield advantage and reliability. Jupiter Asian Income is also another international fund which holds exceptionally good, dividend paying companies. With the risk return trade off becoming more challenging stock-picking is vital to the investor and thereby verifies the importance of a good investment manager. Both of the above funds are incorporated into the MAIA Balanced Income model to capitalise on their Income paying history.

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