After Peak Interest Rates, What’s Next for Income Seekers?

After inflation surged in 2022, central banks aggressively tightened monetary policy, leading to substantial losses in bond markets. While this downturn was a setback for fixed-income and multi-asset investors, it presented a unique opportunity for those seeking income. Compared to the low-interest rate environment that prevailed after the 2008 financial crisis, cash and bonds now offer significantly more attractive yields.

For our analyst’s take on the implications of monetary easing, potential bond income strategies, and the role of equity income, download the full income investing report.

Monetary easing refers to policy actions by central banks aimed at increasing the money supply to stimulate economic activity, often involving interest-rate cuts. For investors, monetary easing can signal a shift in the investment landscape.

Lower interest rates mean borrowing becomes cheaper, encouraging consumer spending and business investment and boosting economic growth. However, it also means that traditional savings accounts and cash deposits become less attractive due to lower yields.

In such environments, financial advisors may need to help investors look beyond cash and consider other asset classes to achieve their income goals. Strategically positioned bonds, particularly those with longer durations, can benefit from falling interest rates as their prices tend to rise when rates drop, making them an attractive option for those seeking stability and growth.

Monetary easing can improve the overall market sentiment, fostering a favorable backdrop for riskier assets like stocks. Equities with strong dividend yields may become more appealing as alternatives to fixed-income securities offering lower returns.

Investors may find that, during easing periods, correlations between asset classes can change, with bonds sometimes acting as diversifiers during equity market corrections.

Despite recent challenges, bonds remain viable for income-focused investors seeking higher yields.

Major bond sectors now offer yields exceeding their five-year averages, making them attractive for investors seeking income without excessive credit risk. In particular, government and investment-grade corporate bonds offer relatively attractive income levels.

Monetary easing can be positive for fixed income. Unlike cash deposits in high-yield savings accounts or CDs, bonds typically see their prices go up when interest rates go down. When interest rates fall, already issued bonds that pay higher coupon rates become more appealing.

High-yield and corporate bonds offer opportunities for elevated returns, but they come with increased credit risk. While credit spreads widened in 2022, credit and high-yield bonds produced strong returns in 2023, underpinned by solid economic conditions and healthy corporate balance sheets.

Generally, bonds remain a critical component of a balanced income strategy, allowing investors to adapt amid market conditions.

Fixed-term bond funds are an increasingly popular tool in the fixed-income toolbox. They received higher net flows than any other fixed-income category in 2023, and so far in 2024, among Europe-domiciled funds and ETFs.

Morningstar data covers 1,061 fixed-term bond funds in Europe, Africa, and Asia as of November 4, 2024.

While equities offer significantly higher risk than bonds, dividend-focused equity strategies can provide investors with yield and greater capital appreciation potential than bonds.

Exhibit 1 shows the consistent dividend yield premium offered by global dividend equities, over the broad market global index. The Morningstar Global Markets High Dividend Yield Index targets stocks representing the higher-yielding half of the global dividend-paying universe, and serves as the Morningstar benchmark for global equity income funds. The Morningstar Global TME index is a broad global equity benchmark.

Investors should be aware that these strategies can have distinct geographical, sector, or style biases compared to traditional equity indexes.

Dividend-focused equity strategies may underperform during periods of strong growth, but they can offer resilience during market downturns, especially when interest rates are falling. Actively managed equity income strategies often consider factors like company quality and dividend growth, which can reduce their overall volatility and exposure to riskier stocks. These strategies can be valuable for investors seeking income and capital appreciation, but they require careful consideration of the risks involved.

For income-seeking investors, multi-asset funds can provide a single, diversified solution that can generate higher income than traditional balanced portfolios, with potential for capital growth. By investing across multiple asset classes, managers have more flexibility to optimize risk, return, and income, while accessing a wider range of income opportunities. This diversification can help stabilize and make income more predictable, even in varying market conditions.Multi-asset strategies can offer higher yields by tapping into equities, fixed income, and alternative investments. By investing in a mix of asset classes, these strategies provide a balanced approach that can reduce volatility compared to single-asset portfolios.

When interest rates decline, multi-asset income strategies can offer stable income and diversification.

As rates fall, the revenue generated from traditional fixed-income sources diminishes. Multi-asset strategies can offer higher yields by tapping into equities, fixed income, and alternative investments. By investing in a mix of asset classes, these strategies provide a balanced approach that can reduce volatility compared to single-asset portfolios.

For clients venturing into income investing, advisors should define their specific objectives and construct a diversified portfolio aligned with their risk tolerance. Conventional benchmarks often lack a yield focus, potentially limiting income generation if used as a guide for asset allocation. However, excessive risk-taking by focusing solely on yield can compromise portfolio quality and long-term performance.

In the current market, bonds offer attractive income potential, but investors should be cautious about overstretching for yield. Advisors need to educate clients on how portfolios behave in different market environments, such as high-rate or low-rate periods, which can help them make informed decisions.

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