This week’s Investment Soundbite Q&A from FundCalibre is with Vincent McEntegart, co-manager of the Aegon Diversified Monthly Income fund, who tells us tells why the bond market is so attractive this year for income seekers.
Vincent explains why the fund has been reducing banking, infrastructure and real estate exposure in favour of investment grade and high yield bonds, as well as looking to the currency markets, to target a 5% yield.
(Recorded 25 April 2023)
Q: The fund aims to produce an income of 5% – how have you achieved that in the past and will this target change now that the world has changed and achieving 5% is perhaps not quite what it used to be?
I have always had the view that why aim for 4% when a 5% income means that you get 25% more income? Who doesn’t want a 25% pay rise?! But you’re right, for most of the last 10 years, getting to 5% has been something that clients may have thought was too high and, in order to achieve it, we would need to take on a lot of risk. The way we’ve been able to deliver it is by looking harder for and investing into securities that first of all have to meet our high standards of financial soundness, but they can have a yield that is anywhere between 2% on the low end, and 7 or 8% on the high end. We don’t have to have securities that all yield 5% – it’s the overall portfolio yield that needs to be around 5%. And that’s just been a continuous process, as markets change, as yields move up and down, we rotate the portfolio.
Today, what’s interesting and different is that after last year, 2022, there’s been a big change in bond markets, so there’s a lot more yield available in those markets than there has been for most of the last 10 years. To give you an example, only about 12 months ago investment grade bonds had a yield that was less than 2%; today, you can get a portfolio of investment grade bonds with a yield of 5% or even 6%. That is a big change in a relatively short space of time.
To sum up the 5% target, it’s achievable from here, although the mix of assets in the portfolio will be a little different from in the past; a bit more fixed income and a bit more in equities that probably have a lower yield, but better growth potential. It’s this flexibility that’s the beauty of investing in multi-asset funds.
Q: You have recently reduced your exposure to banks – has it been in equities and bonds? Or just one asset class?
The banking sector is a challenging sector. The ironic thing is that banks are a really important part of the economy; they have a role in lending to consumers and to companies to help economies grow. But their balance sheets are often quite complicated. They’re not necessarily very transparent, and controversy seems never very far away. We’re fortunate that we have a team of analysts that look very closely at the balance sheets of banks, and that helps us to make some smart decisions when investing there. For a number of years, we’ve had quite a low exposure to the equity of banks, but we have had a meaningful exposure to bonds.
And that’s because we’ve felt that, in a low interest rate environment, it was quite difficult for banks to make a profit. And if you’re investing in equities, you hope that the bank is going to make a good profit and return that to you in dividends and capital growth. But on the bond side, when you invest in bonds, really, you’re just lending money. You expect to be paid interest while you lend that money to the bank, but you just want your money back. It’s a different mindset. And so, we’ve been quite happy to have exposure to the bonds rather than equities.
The recent issues with US and Swiss banks have brought more controversy, volatility and uncertainty again into the banking sector, which has spooked investors. We reduced some of our small exposure to bank equity but have held onto to our bank bonds; we’re not adding to it at this stage, although, one could argue that there are opportunities there, given that prices in both equity and bonds have fallen a bit.
So, an interesting sector which some people choose to just steer clear of, but for a fund like ours, looking for a yield to get to that 5% target, bank credit continues to be an important component.
Q: Turning to equities, tell us how the structure of your equities exposure works in terms of the global and the high dividend allocations you have? You’ve also been reducing your global equity income exposure – is that in preference for any regional or country–specific income requirements?
What we try to do with everything in this fund is, we try not to reinvent the wheel. We try to make use of all of the good ideas that come out of the different investment teams that we have at Aegon Asset Management: the equity side, the credit side, the alternatives side, and we feed them into this multi-asset portfolio.
From an equity point of view, we have a global equity program and that provides the core of our equity exposure, which we then supplement with equities that are held in, for example, the Japanese, European and UK equity programs that we run; we cherry pick these stocks from these programs, to help us to get to our 5% yield objectives.
You are right to say that the headline allocation to equities in the fund has been reduced in recent months. That’s really because, as much more yield has become available in the bond market, we’ve reduced some of our exposure to equities and equity-like assets and put that exposure into the bond market, because the bond market assets are less volatile and less risky than the equity market assets. The area that we’ve adjusted down the most, is in the high dividend equity component. We’ve got about 20-29% currently in the two equity components, and the vast majority of that is in the global equity component, with only about 2 or 3% in the high dividend equity component.
Q: Alternatives have been integral to anyone wanting to achieve a reasonable yield in the past few years. But perhaps some of the more traditional asset classes are looking far more attractive than infrastructure or real estate now. Is that also reflected in your portfolio?
We have actually reduced more in the infrastructure and real estate allocation than we have in the equity part of the portfolio, with all of those reductions going into higher bond allocation. Real estate had a very tough time last year and it’s continuing to struggle. A large part of the reason for that, is that many of these businesses had a long period of time where being able to borrow money cheaply allowed them to run quite a successful business, by just borrowing cheaply and then collecting rents on properties, whether they were warehouses, offices or even residential. And that gap between the rental yield and the cost of borrowing was essentially the business model of many of these property companies. But with the cost of borrowing increasing – and yes, rents may have increased too, but it’s difficult for rents to go up too far – these business models have become much less profitable than they were in the last 10 years or so. That’s a good fundamental reason to be reducing your exposure in real estate, but there are still some good investments. Some of them have been marked down very significantly and look like quite attractive entry points, if you aren’t currently invested there.
More broadly away from real estate, the same concept of cheap funding being the business model also applies in the infrastructure area as well. We had quite a lot of exposure to European utilities, for example. We still have some exposure, but we brought that down in recent months and have now invested the proceeds into the bond market where we’re getting similar yields to what we had in those infrastructure investments, but with a lot less uncertainty around those yields, because they’re bond yields rather than equity-type yields.
Q: Finally, could you tell us about the importance of currency and give us an example of how you’ve taken advantage of this asset class?
Most multi-asset funds – certainly our fund – invest in global assets. We invest in bonds and equities that could be denominated in dollars, in Japanese yen, in euros, in Swiss francs, etc. So, you could have 70% or 80% of your portfolio where the underlying investment is denominated in a currency that is not sterling. Some multi-asset funds wouldn’t manage the currency risk, but we have always managed currency risk. And we can actually also use currency risk to enhance returns and to enhance income.
For example, at the moment we have exposure to the Brazilian real and the Mexican peso in the portfolio. We like those currencies on a fundamental basis. We think those economies are in a good place relative to other economies, and they’re doing quite well. Think of a currency as like the share price of your economy. If your economy’s doing well, your currency should do well, and vice versa. If we think Brazil as an economy is going to do quite well and we’ve got the risk appetite, the risk capacity and the risk budget to invest there, then we can invest in the Brazilian real and benefit from it doing relatively well against other currencies. And it also happens to have a very high attractive level of interest while you’re invested in it. You can think of it as cash in the bank, but it’s not sterling cash in the bank, it’s Brazilian cash in the bank, earning over a 10% interest rate, because that’s what the short-term interest rate is in Brazil.
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