Friday 24 January 2020

Yield is not the only form of investment return -- capital gains must be examined

Central Banks are pumping money into the world at a rate that promises higher inflation. Sluggish economies weigh heavily on the markets, but Barclays Wealth's Dublin-based investment director Nick English believes you can beat rising inflation and get 'real' returns

There is still some real yield out there. Of the strategic asset classes, high-yield bonds, also known as speculative grade credit, offer the biggest real yield.

Over the last two decades, these bonds have offered one of the highest real returns among the nine asset classes that comprise Barclays Strategic Asset Allocation.

We believe that current high-yield spreads provide attractive entry points for clients against a benign default environment.

We're also warming up to investment grade credit, where real yields are in positive territory, and we currently advocate a portfolio of defensive bonds that are likely to be less volatile.

Developed government bonds are our least preferred fixed income asset class and look increasingly expensive.

However, within this asset class, inflation-linked bonds (which are engineered for returns in line with their home country's inflation) provide some positive real return.

Higher-yielding equities are another potentially attractive alternative to low yields in some fixed income asset classes, though they are more volatile.

Insulation

The fact that they do not offer fixed dividend coupons can give them a degree of insulation against inflation.

Aside from their obvious income attractions, high-yielding equity capital values can also outperform the wider market, particularly when the spread between the yield on government bonds and equity market dividend yields is in negative territory, as is the case at the moment.

For investors concerned about inflation in a wider context, we recommend a portfolio tilted towards companies that show 'pricing power'.

These are companies with the ability to pass higher input costs on to their customers, either through the strength of their brand or through regulated, inflation-adjusted revenue streams.

Utility companies are a good example of the latter. There tends to be a government body or a regulator that sets utility rates and may either explicitly tie prices to an inflation index, or at least take inflationary cost increases into account when approving rate increases.

Utility companies also benefit from the industry tendency to finance capital investments with long-term, fixed-rate bonds. As asset values rise with inflation, liability costs remain fixed. The result is lower effective leverage.

It's worth noting that not all companies subject to government price setting will necessarily be well positioned, and many companies that are protected from inflation may not be attractive investments for other reasons.

But an allocation to selected regulated companies should be part of a diversified inflation hedged portfolio.

Companies with a powerful global brand can be another potential weapon against inflation. Well-known brand names impart an element of monopolistic pricing power on their owners.

A good example of this is luxury goods companies. The cost of the materials used to make the end product traditionally forms only a small part of the end price charged to the customer.

Rising input costs are therefore more easily digested by the company and the consumer.

For the foreseeable investment horizon, the challenge of low and often negative real yields will persist.

Central bank focus will continue to be on growth at the expense of possible increased inflation.

So interest rates will remain low and investment income could be subject to further erosion even if inflation does fall back a little as we expect.

For investors seeking real return there is no magic bullet, no single investment that serves as a perfect hedge in all periods of inflation. In our view, a balanced portfolio is the best weapon against negative real returns.

Yield is not the only source of investment return, and capital gains should also be viewed in real terms.

Nick English is investment director, Barclays Wealth, Barclays Bank Ireland.

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