The Age of Income MAY 2015

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1 This is for investment professionals only and should not be relied upon by private investors MAY 2015 The Age of Income Since the financial crisis, investors hunt for income has intensified, pushing down yields across many asset classes. In the continuing environment of excess global capital, low growth, low interest rates and population ageing, demand for attractive income sources is likely to remain strong in the years ahead. This perspective takes a look at income investing across the three major asset classes of equities, fixed income and real estate, before also considering the multi-asset context. THE POST-CRISIS REDUX The post-financial crisis world has largely been characterised by low economic growth and low yields. In order to aid economic recovery, interest rates were cut to virtually zero in many regions. When this proved ineffective, central banks resorted to quantitative easing (QE), which pushed bond yields even lower, to new record lows. An express motivation of these actions was to force investors to take more risk by investing in higher-yielding assets in a bid to boost confidence and create a positive impact in the real economy. In bond markets, yields and credit spreads in higher risk segments such as high yield have been pushed down to very low levels. In equities too, many leading global markets are trading at record high price levels well above their crisis period lows, yet yields remain attractive. Chart 1: The post-crisis yield environment Yields (%) at 15/05/2015 Pre-crisis yields (%) at 01/08/2007 AT A GLANCE In the post-financial crisis world of low growth and low rates, the hunt for an attractive yield goes on. The savings glut and secular stagnation hypotheses argue that low growth and low yields are here to stay. In most asset classes, income returns tend to be a more reliable contributor to total returns than capital returns. Despite a sustained period of strong performance, equities continue to offer attractive income opportunities. With significant yield compression and the onset US monetary policy normalisation, fixed income markets warrant careful risk management. However, fixed income markets can still offer attractive selective income opportunities with generally lower risk compared to equities. Select real estate markets continue to offer compelling stable income prospects. For many investors, a multi-asset approach that invests in a diverse range of low-correlation assets could be an ideal means of achieving an attractive and stable income. $ Cash 1 mth Cash 1 mth Cash 1 mth Cash 1 mth US 10Y Gov. German 10Y Gov. UK 10Y Gov. Jpn 10Y Gov. US Corp. Bonds EMU Corp. Bonds UK Corp. Bonds Jpn Corp. Bonds US High Yield EMU High Yield UK High Yield Asian High Yield EMD EU Real Estate UK Real Estate US Equities European Equities UK Equities Jpn Equities Source: Datastream as at The red line shows the yields available five years earlier. Real estate yields: FIL/CBRE, IPD, end Q and Q WHY THE HUNT FOR YIELD WILL GO ON There are some very good reasons to believe that investors hunt for yield will go on. Firstly, across all major asset classes, it is clear that income is generally a more reliable and less volatile component of returns than capital returns. Secondly, in the post-crisis world, economic growth has remained below potential with an excess of savings over investment pushing up the supply of global capital. Moreover, the savings glut and secular stagnation hypotheses argue that the excess of global capital is a longer term phenomenon that will keep a lid on both economic growth and market yields for many years. In this macro-constrained environment, the search for yield will go on and

2 achieving sustained capital growth could be tougher compared to achieving sustainable income returns as a result, the latter s share of total returns is likely to grow over time. Thirdly, demographic trends will continue to support demand for income strategies. With average life expectancies increasing markedly over the last 50 years, more people are moving into retirement and also living longer in retirement. According to Moody s, a credit ratings agency, the number of super-aged countries where more than one in five of the population is 65 or older is expected to grow from three currently (Japan, Germany and Italy) to 13 in 2020 and 34 in These demographic changes will be a powerful and sustained source of demand for income strategies going forward. Chart 2: Proportion of global population 60 years and older Number m 11% of total worldwide population 2030 Number 60+ 1,375m 16% of total worldwide population Number 60+ 2,031m 22% of total worldwide population Source: HelpAge International, August 2014 EQUITY INCOME In the post-crisis world of low growth, low interest rates and low inflation, the forgotten value of investing in income-generating stocks has reasserted itself. As with equity markets generally, dividend-paying stocks have recovered and re-rated significantly. This has inevitably had a compressing impact on dividend yields. However, the equity income approach remains attractive because improving corporate performance has also enabled dividend payments to rise significantly. Indeed, as Chart 1 on the previous page shows, equity yields appear somewhat anomalous in terms of how little they have eroded in the post-crisis period compared to other asset classes, despite the strong performance of the past few years. As Chart 3 below shows, dividend yields in most key markets today remain above their 15-year averages. Moreover, it is possible to argue that income from equity is cheap compared to income from bonds where it s clear that yields across the credit spectrum have eroded considerably in the post-crisis period. In Europe for example, over 70% of companies offer dividend yields above their corporate credit yield, far above the 15-year average of 18%, as depicted in Chart 4. In today s low interest rate world, I think equity markets are a good place to look for investors seeking an attractive level of income. Michael Clark, Portfolio Manager, UK Equities Chart 3: Dividend yields still above their 15-year averages Source: Datastream, May World Japan US UK Europe ex-uk EM Current yield % 15-year average yield % Asia ex- Jp Chart 4: % of European cos. with dividend yields above bond yields 70% 60% 50% 40% 30% 20% 10% % of companies with DY>CY 0% Source: Source: Goldman Sachs, May 2015; dotted black line shows 15-year average level

3 In the current environment of increased valuation multiples, equity income investing offer some defensive benefits. In particular, dividend-paying companies tend to be more concentrated in defensive areas providing reliable cash flows and for investors this can provide a valuable element of downside protection in the event of capital losses. The ability to grow dividends is also important because apart from permitting higher valuations, this can provide an element of real income protection. However, good stock-level research is especially paramount when looking for dividend stocks since dividends are liable to be cut or get completely wiped out if business conditions worsen deep fundamental research to determine which companies can not only sustain but also grow their dividends, is therefore of critical importance. FIXED INCOME Arguably the impact of the prolonged low growth, low inflation and low interest rate environment has been the strongest on global fixed income markets. In the so-called riskfree group, the US 10-year Treasury yield although now above its record low level, is still very low compared to history. Remarkably, in Germany, amid ECB QE, the 10-year Bund yield fell to a record low of 5% in April The impact of these very low risk-free yields has been sustained strong demand for higher-risk/higher-yielding assets, such that spreads in some credit markets are near to low levels compared to history. At the same time, there are increasing signs that as in the period leading up the financial crisis, investors are becoming more inventive in how they go about extracting additional returns, for example through increased leverage. Understandably, the sustained period of yield compression in credit markets is causing investors to become more circumspect. However, while a more cautious and more selective approach may well be warranted, it is also true that fixed income continues to offer a wealth of attractive and relatively low-risk income sources for investors and significant asset level diversification benefits. For investors concerned about valuations, a key point to note is that current low yields and low spreads are entirely appropriate for the current backdrop characterised by record low interest rates, low inflation, robust corporate balance sheets and low corporate default rates (see charts below). In the current environment, consistent income and good risk-adjusted returns can be delivered through fixed income assets via the careful management of both duration and credit risk. Ian Spreadbury, Portfolio Manager, Fixed Income Chart 5: Inflation below central bank targets Current inflation Central bank target US 0.3% 2.0.% Eurozone % <2.0% UK % 2.0% Source: Fidelity World Wide Investment, May US inflation rate is the PCE rate. Chart 6: Low corporate default rates 3.5% 2.5% 2.2% 2.3% 1.7% 1.5% 0.5% -0.5% Global US Europe Source: Moody s Research, April 2015 Chart 7: Market expects a low Fed Funds Rate 4% 3% 2% 1% Fed Funds Target Rate Implied Rate 0% Feb-08 Feb-12 Feb-16 Source: Bloomberg, May 2015; implied rate based on forward swap rate curves The favourable backdrop notwithstanding, it is also true that the current more mature phase of the credit cycle and ongoing US monetary policy normalisation all point to a potentially more risky environment. This calls for a more selective and flexible approach on the part of fixed income investors. Given the widespread expectation of rising US rates, reduced duration exposure is logical but investors should also be wary of the dangers of straying too far in this direction. In particular, it should be borne in mind that moderate levels of duration provide downside protection in the event of any adverse macro shocks as well as well as maintaining the traditional low correlation/diversification benefits of bonds in the context of a multi-asset portfolio. While corporate conditions are currently favourable thanks to strong balance sheets and low default rates, low spreads coupled with potential signs of over-exuberance in terms of corporate activity should serve to underscore the importance of diligent credit research. Aside from careful management of duration exposure and credit risks, diligent fixed income investors should also pay close attention to liquidity conditions and potential tail risks, such as geopolitical and inflations risks. Given the variety of risks, the flexibility of a strategic bond fund approach remains a highly effective all-round solution for many investors.

4 COMMERCIAL REAL ESTATE Investors look to commercial real estate for a number of reasons. Physical real estate tends to have low correlation with other assets and can offer significant capital growth potential. However, a wealth of data from across the developed world shows that by far the most important driver of long-term real estate returns comes from the income element. Moreover, not only are income returns a key contributor to overall of commercial real estate returns, they tend to be vastly less volatile compared to capital returns. The income advantages of real estate are clearly summarised by the relative stability of the red bars (income component) compared to the blue bars (capital component) in Charts 9 and 10. Interestingly, a quite specific implication of this for real estate investors is that assets that derive more of their target returns from income rather than capital growth expectations are likely to offer better risk-adjusted returns. Income - the key driver of real estate returns The stability of the income component of returns % pa Prime European All Property Income return v Capital returns - % pa 1981 to Income Return Capital Growth % pa Prime Europe ex UK and Moscow All Property Income Return v Capital Growth - average % pa 1981 to Income Return 0.7 Volatility of income component 6.5 Capital Growth Volatility of capital component Chart 8: Source: Jones Lang Lasalle, May 2015 Chart 9: Source: Jones Lang Lasalle, May 2015 In the post-crisis world, the commercial real estate asset class continues to offer good opportunities for investors looking for an attractive income. The asset class yield comparison chart on page one nicely illustrates the comparative advantages of real estate as a source of income all subsectors of the European prime real estate market offer yields that are comfortably higher than the dividend yields available in equities across all regions; in addition, unlike high yield bonds, the income level attainable has remained at a level similar to or higher than before the crisis. Moreover, on an absolute basis too, European real estate yields appear attractive compared to other classes. Remarkably, in the upper tier of secondary European real estate markets, yields of 6% or more are still attainable on good quality assets. Arguably, the nearest income competitor to real estate in today s world is the high yield bond class, but for many income investors, real estate may be a more attractive option because it is a real asset and has little of the associated valuation concerns currently surrounding high yield. A key general advantage of real estate compared to non-inflationlinked bonds is the ability of income returns to rise, owing to the scope for rents to be adjusted upwards, thereby providing a valuable element of inflation protection. In the continuing low rate environment, attractive and reasonably priced income alternatives have diminished but selected commercial real estate markets still offer some compelling opportunities. Keith Sutton, Portfolio Manager, European Real Estate MULTI-ASSET INCOME Today s environment of low economic growth and low yields has resulted in investors being pushed further along the risk spectrum in the search for an attractive level of income. Although harder to come by, assets which deliver a strong income are still available, but each of these has its own set of risks and potential drawbacks. In this context, investors looking for an attractive and sustainable income have increasingly been turning to dynamic multi-asset income approaches. These portfolios are typically configured to diversify the different risk and return factors in order to reduce overall volatility and enhance income stability while also having the ability to tactically adjust allocations in order to take advantage of changing macro conditions and different phases of the market cycle.

5 Table 1 below illustrates how different income-generating asset classes tend to behave over different phases of a market cycle. Generally speaking, traditional income assets like government and investment grade bonds or cash tend to perform well in deflationary periods, but less well in periods of inflation. The reverse is true for growth-and-income assets like equities or real estate. Meanwhile, the responses of different asset classes to economic growth are always specific to their individual characteristics. Table 1: Income sources behave differently throughout a market cycle Source: Fidelity Solutions. This chart represents the opinion of Fidelity Solutions, and is for illustrative purposes only. For many investors, a global multi-asset income approach that invests in a range of assets with different yield, volatility and inflation characteristics can be an effective means of achieving a stable and competitive income. Eugene Philalithis, Portfolio Manager, Multi Asset Income range We are currently in a recovery phase of the global economic cycle. In this climate, assets such as high yield bonds and equities tend to provide stronger levels of income compared to traditional income-generators like government or investment grade bonds. However, it is important to position income portfolios for the prevailing specific market conditions. Diversified income portfolios spread risk across asset classes, thereby reducing volatility compared to a single-asset portfolio of growth assets. In particular, the best multi-asset income portfolios will look to dynamically combine assets with low correlations in order to reduce portfolio volatility while also aiming to provide a stable yield. CONCLUSION In the post-financial crisis world of low growth and low rates, investors hunt for attractive and stable sources of income goes on. The appeal of income-focused strategies is reinforced by the fact that in most asset classes, income returns tend to be a more reliable contributor to total returns compared to capital returns. Moreover, with the ever growing numbers of people reaching retirement and living for longer, the demand for attractive sources of income can only grow in the future. This is a powerful long-term source of demand for income strategies and, in turn, income-producing assets. In terms of the key asset classes: Despite a sustained period of strong performance, it is clear that dividend yields across most global markets have held up remarkably well and therefore continue to offer good income opportunities. In fixed income markets, the backdrop of significant yield compression and the backdrop of US monetary policy normalisation makes for a more challenging environment. But despite this, it is clear that experienced professional investors are continuing to deliver good risk-adjusted returns through dynamic risk management. In commercial real estate, the yields available on good quality assets in some markets continue to compare highly favourably to all other asset classes. Finally, for many investors, a multi-asset approach that diversifies across different income sources is an effective strategy for achieving a competitive, stable income. If investors subscribe to the savings-glut thesis as I do, and accept that we are likely to remain in an excess capital environment that keeps yields low, then portfolios should be reviewed to focus principally on long-duration assets that provide real returns. This argues for buy-and-hold equity and real estate strategies that allow for the reinvestment of dividend and rental income distributions. Dominic Rossi, CIO Equities

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