Yields, diversification and credit risk

With the recent move in interest rates to record lows, income-seeking investors have started looking for yield elsewhere. The publicly traded stocks issued by companies that pay healthy and consistent dividends have become increasingly attractive to many investors. And even though the prices of some of these stocks may have languished in recent years, the dividend payments continue to make these investments appealing to buy-and-hold investors whose primary focus is the ability of the portfolio to generate a non-volatile income stream, while growth in the (paper) value of the portfolio is a secondary objective. Consequently, equity dividend investments are being increasingly viewed as an alternative to fixed income, and as a result the marketplace has seen a proliferation of dividend-focused products.

This phenomenon, however, is very recent. Traditionally, from the perspective of investors, the role of fixed income or debt investments was two-fold: first, diversifying the equity risk within a portfolio, and second, generating income. Dividends from equity investments were viewed as the icing on the capital-appreciation cake—a small additional reward to compensate for the uncertainty in stock prices.

Critics argue that, as of late, fixed income has failed to live up to both its roles. During the first major market downturn of the new millennium—the technology bust of 2001—equities declined significantly while fixed income returns were slightly positive or flat. This raised doubts as to the diversification benefits of fixed income when they were needed the most. When equity prices fell steeply in 2008, fixed income returns were flat yet again, but this time real estate also crashed. This led some investors to hypothesise that diversification was dead. In addition, due to a falling interest rate environment, fixed income yields have also been declining. Yields have fallen so low that investors fear fixed income could be yielding negative real (i.e. post-inflation) returns.

This article has three objectives. First, to present the historical performance of fixed income in the context of its two key roles in an investment portfolio: income and diversification. The second objective is to compare the historical performance of fixed income with the performance of other asset classes—particularly equities and real estate—that compete with debt investments in terms of asset growth (price return) and income (yield). Lastly, since volatility in fixed income is driven by other factors besides market risk, the article seeks to highlight the credit risk inherent in the asset class.

GLOBAL BONDS PERFORMED LIKE GLOBAL STOCKS—BUT WITH LOWER VOLATILITY

Figure 1 presents the cumulative performance of global bonds, as measured by the Barclays Capital Global Aggregate Bond Index, and the performance of global equities, as measured by the Dow Jones Global Total Stock Market Index. The performance is presented from 1992 to the first quarter of 2012. These indices were selected to represent the asset classes because both are broad indices designed to benchmark the respective marketplace. The Barclays Capital Global Aggregate Bond Index is a market value-weighted portfolio that includes government, corporate and other securitised bonds from the US, Europe and Asia Pacific, with varying credit quality and maturities. Its history goes back to 1 January 1990. The Dow Jones Global Total Stock Market Index is a free-float market capitalisation-weighted portfolio that currently includes over 12,000 publicly traded stocks from 76 countries representing 100% of the free float market capitalisation for the US, 98% for developed markets, and 95% for emerging and frontier markets. The history of the index goes back to 1 January 1992.

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