The Ingredients of Income

The Ingredients of Income

Covid-19 continues to have a firm grip on the financial markets. While stocks in general have been climbing back from the pandemic-induced falls they experienced in the first quarter of 2020, it is unclear how long this recovery can last. It sure is a bumpy ride. Understandably, many investors who pulled their money out of the declining markets, proceed to stay in the short-term safety of cash. They need help to get back into the markets and put their money back to work in the context of near-to-zero interest rates.

One way to re-enter markets in times of volatility is a strategy that focuses on income. In general, investors will be aware that total return is made up of two components: price appreciation and income. Typically, the income part of that equation is more stable than prices, which can fluctuate dramatically. If a large portion of an investor’s return is from income, he or she may be able to limit their uncertainty. 

The asset class with all of its return from income is cash. But with interest rates at record lows, cash accounts – and, for that matter, money market instruments in general – are yielding next to nothing. However, investors can find alternative sources of income in bond coupons and dividend income from equities.

Bond coupons 
Bonds are somewhere between cash and equities. Owning bonds is all about getting a higher yield – or income – than a cash deposit or a money market product can offer, with less downside risk than equities. So, for the more conservative investors among your clients the income stream offered by fixed-income investments are a viable solution. Obviously, it needs to be explained that different bonds offer different levels of income and risk.

Dividend income from equities 
But investors may also wish to hold shares in their portfolio. Over time, owning shares in well-managed companies has provided the greatest opportunities not only for capital growth, but also for income generation through dividends.

One way of highlighting the extraordinary impact of dividends is by comparing an index’s performance by price return versus total return. For example, the S&P500 is a price index. Dividends are not included in the return calculations. Historically, the dividends paid by companies in the S&P500 have fluctuated between two and five percent per annum. If reinvested, this adds up to significant returns over time and makes the benchmark’s performance look even more impressive than its price appreciation alone.

However, investors need to understand that the current environment could be here to stay for quite a while, and there could be a long “muddle-through” period before things improve significantly. That means, a lot of companies are going to struggle, and more will have to cut their dividend. By contrast, those companies with strong cash flows and healthy balance sheets that are able to sustain and even grow their dividend are going to be increasingly prized.

Portfolio construction 
The bottom line is, investors who construct a portfolio containing cash, bonds and equities and maintain a focus on income should be able to weather the current market difficulties. They should also be well positioned to benefit from a market recovery and enjoy consistent long-term results.

In order to achieve a high level of diversification – that is diversification within an asset class – investors often opt for funds: money market funds, fixed-income funds, equity funds etc. 

In the past two decades, investors have increasingly turned to passively managed funds which makes sense where the fee item as part of the income calculation is concerned. 

Consequently, your clients are becoming more and more appreciative of the fact that certificates on indices constitute an even less expensive alternative, offering the same levels of diversification within an or across asset classes. When tradable cost-efficient and fully flexible, higher holding-period returns can be realised.

At Spectrum, we’ve set new standards for what can be referred to as “fully flexible” in that we have introduced intraday issuance, a pan-European ISIN, a 24/5 trading service, the highest possible levels of transparency and security as well as an unparalleled degree of liquidity for structured derivatives on indices, currencies and commodity derivatives. Get in touch today to learn more about the opportunities Spectrum holds for your retail client business.