In today's low-yield environment investors must take a flexible approach to income investing, says Anne Lester, a portfolio manager with JP Morgan's Global Multi-Asset Group. We sat down with Anne at JP Morgan Asset Management's recent investment conference to learn a bit about her team's strategy for income investing while managing risks, areas of opportunity for income investors, as well some recent headwinds for the emerging markets.
Jason Stipp: Anne, you run an income portfolio. You have a lot of flexibility to invest in different areas of the market. We've seen tremendous demand for income from investors of all stripes.
What areas in the income sectors are you emphasizing right now given that we are seeing yields so low in several areas of the market? Where have you found income that you think is a good bet right now?
Anne Lester: Well, high-yield is always a great place to start. Like its name implies, it's really the best yielding asset class that we see out there, and even though it's rallied a lot from the risk-off sell-offs that we saw earlier this year and also in the third and fourth quarter last year, we still find very attractive yields, sort of 7% to 8% in absolute terms, which we think are quite attractive. So high-yield we like. It's a risk asset, and we don't think it is a substitute for an investment-grade bond portfolio, but instead of owning equities, if you think about its role in portfolio construction, we think it pays a great yield, and it will participate in the upside to the extent to which we see the economy recover and we see a rally in risk assets, but it's also going to be a little more protected on the downside, and we also saw that play out in the most recent sell-off where it sold off, but not nearly as much as the equity market did.
Stipp: You also have an emphasis on non-agency mortgages. Can you talk a little bit about your investment thesis there?
Lester: Sure. That's a position we started building in this fund almost two years ago, and one of the things that we saw on the institutional side is this ability to do recovery funds, and we really thought it would great to tap into that ability to find securities that we think have just gotten beaten up, but the trick we think to doing that well is to have a team that can do bottom-up due diligence at a very granular level when we're buying these bonds.
So we started allocating capital here, like I said, I think almost two years ago, and it's certainly played out enormously well. There again, you are getting absolute yields even higher in some instances than you are in the high-yield market, but it's a little more illiquid, and despite its mild yield premium, probably not something from a liquidity perspective you feel comfortable putting a ton of money into. And of course, the housing market has not been improving over the course of this, so the security selection we think is important. But we are hopeful now that we are starting to see signs that the housing market is, in some markets, actually recovering and certainly in others sort of bottoming out, and that also gives us some conviction to continue holding that position.
Stipp: I'd like to talk to you a bit about Treasuries. Now this is not a place where you would look for yields obviously, but they continue to rally. Treasuries for a long time have looked like a really bad bet, but yet we saw in the second quarter 10% plus for long-term Treasury return. When you are thinking about income and the role of Treasuries overall in a portfolio, how do you work with that investment type right now?
Lester: So, in theory, a Treasury or even cash ought to be something you look at for yield, right. It ought to be something in your opportunity set. It's pretty much for the whole life of this fund been something we thought was really unattractive, and we started the fund about five years. So over the past five years, Treasuries have been unattractive.
We actually have owned Treasuries or Treasury futures as a way to manage some risk in the portfolio, and that's something we still do today, and that is Treasuries have been the only thing that have been negatively correlated with risk assets. So we think they are kind of a lousy investment for income if you compare them to high-yield, let's say, or non-agencies, or emerging market debt or just about anything. But as a portfolio construction element or as a risk-management element, we think they can add actually a lot of value to the portfolio, and so we have from time to time allocated money to Treasury futures to buy duration, but we haven't really done that for income, we've done that for risk management.
Stipp: So you mentioned Treasuries there in talking about risk. I just want to talk to you about risk overall when you are looking at a yield or an income strategy. Because yields are so low, we've been concerned that folks have taken on more risk than maybe they are anticipating to try to get that yield. They are reaching for yield, so to speak. How do you think about risk and settings some guardrails for risk when you are looking for income in an environment where income is hard to find?
Lester: I think the most important thing to do is to think pretty carefully about how much risk you are willing to take, and you can think about that risk in conventional portfolio construction terms. So we articulate the level of risk we are targeting to be at or below in our Income Builder Fund as that have a 60-40 stock bond portfolio, where 60% is in global equities, 40% in the [Barclays US] Agg [Bond Index]. That in normal times would give you a volatility of somewhere between 10% and 12%. So what does that translate into? Well, if you have a bad patch that would translate into a loss of maybe 20% or 25%, right, just doing the math. So that's a big question: Is that a level of volatility somebody is comfortable with? We think, given that level of volatility, you can generate a pretty interesting income, something certainly around 5%. But if you want less volatility than that, it becomes very hard, I think, to try to generate yields that are over 2% or 3%. It just gets very hard.
Stipp: You also talked a bit about some of your macro themes. You look at different time ranges and you mentioned recently that your take on U.S. developed versus international developed has changed. What are the changes there and what drove them?
Lester: Well, it's really all about the European financial crisis right now, and sort of a tactical view. We're not huge fans of Europe. That's not to say there are not some great companies in Europe, and in fact we do own a number of individual names in Europe. But overall, just from a straight sort of top-down macro asset allocation perspective, we think Europe is going to struggle for a while. I think it is unclear how the current crisis resolves itself in any shorter time period that we can define--6 months, 12 months--I don't know what the catalyst is to make this thing go away as a problem, and so it's going to be a major headwind for the markets.
Stipp: So would you say that the risk is not really priced in to European stocks in your view if you think compared to U.S. stocks, they are not as attractive?
Lester: No, I think the risks are pretty well priced in. I just think that you're still looking at really catastrophic outcomes and really slow growth, and you put those two things together, and say you're in for a recession of some sort and what we're debating now is how severe it will be and how long it will be, and that's just not a great climate for stocks. At some point things are going to get cheap enough that you do want to jump back in, but I don't think we're there yet.
Stipp: You also spoke today about a decoupling trend that you're seeing, and I think for everyone, the memories of 2008, although it's several years ago now, are still very fresh, where we saw really no decoupling. Everything was moving in tandem, except Treasuries, obviously. What decoupling trends are you seeing now and what's driving those?
Lester: Well we're seeing decoupling at the economic level more maybe than the market level, right. So when I speak about decoupling, I'm really thinking about inflation and growth. And if you go region-by-region, and say inflation can be increasing or decreasing and growth can be increasing or decreasing; a year ago, inflation was rising and growth was slowing just about everywhere in the world, and that convergence in macroeconomic environment also, we think, meant that there was some convergence in the markets.
When we look around the world today, we're seeing a much more balanced or mixed picture, where some parts of the world are seeing inflation go up, others down, growth is still accelerating in some parts of the world, although it's trailing off a little bit, and so that divergence we think is just ... diversification is good, we think. So maybe if the whole world were accelerating together we wouldn't mind that so much, but otherwise we think having a little bit of balance is a good thing, and that makes us feel a little happier about the prospects for more stable growth going forward.
Stipp: One of those areas of the world that investors are paying very close attention to, because it has been really the only place where they could get decent growth, is emerging markets--although recently we've seen some concerns about emerging markets slowing down. In your portfolio what role do emerging markets play, and what's your outlook for the prospects for emerging markets at this point in time?
Lester: Well it's interesting. Actually right now I think those two things are a little in conflict with one another. I think our shorter-term outlook for the emerging markets is that there are some real headwinds there. And by shorter term, I mean sort of 12-18 months. Whether it's the slowdown from China rippling through the emerging markets in Asia, or whether it's the European financial crisis potentially leading to some more difficulty in raising capital, especially in Latin America from some of the Spanish and other European banks, we think that that is possibly going to be challenging. Looking beyond that time horizon, we think the prospects for growth are actually pretty good.
However, we also think that there are number of very high-quality emerging-market equity companies in telecoms and utilities and other sort of traditional income-generating sectors where we think the prospects for growth are quite good, and these are typically very low beta stocks that pay very high dividend yields. So for a portfolio like Income Builder, we've got over a third of our equities in the emerging markets, which is actually way more than we do in our non-income portfolios, and that's because we're getting great income and very low beta exposure to the emerging markets. So maybe something like a 6% yield, and we're measuring the effective beta or risk in our portfolio at just over half of the regular market, which we think is a pretty good deal.
Stipp: Anne, thanks for your take on the income environment today and giving us a peak into your portfolio.
Lester: You're welcome.