The current economic environment is a challenging one for investors. Global economic growth is projected to be just 3.1% in 2016, rising only slightly to 3.4% in 2017, according to the International Monetary Fund's latest World Economic Outlook. Meanwhile low inflation and low interest rates persist in many markets, making sustainable yields hard to come by.
Negative bond yields
The challenging conditions have led to government bond yields turning negative in many developed markets. Switzerland started the trend last year, when it became the first country to effectively charge investors for lending money. It was followed by Japan, whose 20-year government bond yield turned negative for the first time ever in July, as investors sought safe havens following the United Kingdom's shock decision to leave the European Union. Returns on 2, 5 and 10-year Japanese government debt are all also in negative territory.
Meanwhile, Germany recently claimed an unwanted record when it became the first Eurozone country to sell a 10-year government bond with a negative yield. A host of other Eurozone countries now also have negative yields on their government debt.
Unsurprisingly, the current situation has dented investor confidence, leading to a search for alternative sources of positive yields on their money.
Traditional yield-generating investments
Government bonds in established, developed markets, such as the US, UK and Europe, have previously been a key asset for investors seeking yield. But even where returns on government debt are still positive, yields are at or close to record lows. For example, returns on two-year US Treasury bonds were just 0.75% at the time of publication, while returns on five-year UK gilts were only 0.2%.
High quality corporate bonds have historically been another option for investors seeking yield. But, like government bonds, returns on this asset class have also been trending downwards in recent years, with the average yield on triple-A rated UK corporate bonds recently falling below 1.4%.
Alternative yield-generating investments
With traditional yield-generating asset classes suffering in the current economic environment, other asset classes are starting to catch investors' attention.
One such asset class is emerging market debt. Emerging market debt mainly refers to bonds issued by governments in less developed countries and can be denominated in either 'local currency' or 'hard currency'. The later refers to emerging market debt issued in foreign currencies and predominantly in US dollars rather than the countries' own currency. More than 35 countries are classed as emerging markets, but the four largest are Brazil, Russia, India and China, dubbed the BRIC countries. Emerging market debt is considered to be riskier than the sovereign bonds issued by developed countries due to the increased economic and political risks these countries face, but the returns are correspondingly higher, with yields often in the mid to high-single digit range, depending on how much risk investors are willing to take.
Emerging markets have benefitted from two significant changes in the economic outlook during the first half of 2016, namely an improvement in commodity prices, with many developing economies heavy exporters of commodities, as well as expectations that US interest rates will not be increased as quickly as previously expected. But it is important to bear in mind that many of the countries still face significant political uncertainty. Even so, the higher yields on offer are clearly catching investors attention, with retail investors in Hong Kong more than doubling the amount of money they put into emerging market bond funds during the second quarter of this year, with gross investments totalling US$139m, up from US$26m in the first three months of the year, according to the Hong Kong Investment Funds Association.
Commercial real estate
Investors looking for yield are also turning their attention to commercial real estate, which continues to offer attractive returns compared with some other asset classes. Individual investors can access commercial property through Real Estate Investment Trusts or REITs. These are collective investment vehicles that operate like a mutual fund, investing in large-scale buildings, such as shopping centres, offices and hospitals. The funds receive a steady income through rents on these properties, most of which is paid back to investors through dividends. Yields are typically around the 3% to 4% mark, although returns on some funds can be much higher. Like emerging market debt, REITs have also been gaining in popularity, with gross investments in Hong Kong rising by 60% to reach US$9m in the second quarter.
Real estate related investments should generally be considered for investors with medium to longer term time horizons due the nature of the underlying assets. However, one key differentiating attribute of investing through REITS, when compared to investing in 'physical property' is that it offers investors greatly improved liquidity. This is due to the fact that REIT shares can be bought and sold on a stock exchange and thus generally offer daily liquidity in most instances which appeals to investors with potential liquidity needs.
Weighing up the pros and cons of different yield-generating investments can be challenging, so you may want to consult a professional adviser to help you achieve a sustainable income.
© 2016 Standard Life
