Giordano Lombardo, an avid reader of Italian history and CIO and deputy CEO of Pioneer Investments, the €196 billion ($241 billion) asset management firm headquartered in Milan, notes proudly that it was the Italian city-states of the 14th century that invented the public debt market.
The interest on Italian public debt is still enticing investors more than six centuries later. Lombardo adds in the next breath, however, that the returns on Italian government debt — and on sovereign debt across the developed world in general — are no longer enough for many investors. Yields on ten-year Italian government bonds, for example, have fallen to 2 percent. Even at this level, they are almost three times higher than ten-year rates on Bunds. The low level of income that the bond market offers presents a conundrum because “a combination of structural forces and cyclical elements in financial markets is creating this enormous demand for income,” says Lombardo, who will become CEO of Pioneer, a unit of Italian bank UniCredit, in January.
The structural forces include rising life expectancy, which is producing a lopsidedly older population that wants to live off regular income for the decades after retirement, and the deteriorating funding position of public pension systems, which is increasing the need for people to invest and save for their golden years.
Pioneer’s solution is to adopt a multiasset approach: still investing for income but doing so through a diverse strategy that includes a highly activist approach to bond investing, which also takes in loans. Most strikingly, it also involves investing in high-dividend stocks, with a twist: It boosts income returns by selling call options on them.
This approach is proving popular with investors. Net inflows into flexible income products, including multiasset funds, totaled €4.2 billion between the beginning of the year and late November. Multiasset strategies account for, according to Lombardo, at least 70 percent of Pioneer’s net new inflows at the moment. Boosted by inflows and by investment returns, Pioneer’s assets under management have risen by 27 percent since December 2012.
The returns that Lombardo regards as achievable depend on the strategy preferred by investors, which in turn depends on how much volatility and risk they are willing to accept. For a global fixed-income strategy — eschewing other forms of income, such as stock dividends — Pioneer targets 3.5 to 4 percent returns. Pioneer is, he notes, seeing increasing interest in global fixed-income investing among U.S. institutional clients. For global fixed income, present bond yields, which are generally rather low, are merely the starting point.
“You can play the market in tactical ways to add further sources of income,” notes Lombardo. “For example, you can overweight or underweight high-yield, according to your view of the sector.”
The right time horizon for these tactical plays is, says Lombardo, 18 months to two years. That gives Pioneer the latitude to get into and out of sometimes illiquid markets at a favorable juncture, as well as enough time to wait for its views about the economic cycle to be reflected in asset prices. Returns can also be enhanced, says Lombardo, by tactical views of currencies. “Fixed income needs to offer a much broader answer to income solutions than traditional core bond funds,” he explains.
Christoph von Reiche, European head of institutional at $1.7 trillion J.P. Morgan Asset Management in London, endorses the notion that in the present low-yield environment, investors fishing for income need to cast their net more widely than before. Direct lending — “entering the void left by banks,” as von Reiche calls it — is one way to get around this situation. According to him, it provides an alternative for investors who would previously have gone into high-yield bonds, whose yields have been driven down. “I think it provides a very attractive return to long-term investors, by allowing them to capture the illiquidity premium,” von Reiche says.
Investing for income in the new environment should not, however, mean that investors have to alter the main constituent parts of their portfolios beyond recognition. “It’s about extending investment styles, rather than coming completely out of your strategic asset allocation,” says von Reiche. For J.P. Morgan Asset Management, direct lending is an example of this. For those investors who want to keep large allocations in income-producing assets, it is a solution rather than an alternative.
Another option to boost income returns is loans. Pioneer invests in these through the primary and secondary market. These investments include collateralized loan obligations and loans to infrastructure projects. But infrastructure, says Lombardo, “can only play a limited part in a multiasset strategy, between 5 and 10 percent of the total solution, because it’s relatively illiquid.”
For investors prepared to accept more risk, equities present another option, with Pioneer targeting income returns of about 7 percent. This is made up of 5 percent in dividend yields, which can, says Lombardo, be achieved through careful global stock selection, and 2 percent by selling call options. Pioneer writes calls for about 10 percent of an equity portfolio used in income strategies. It does not write calls for stocks in which it sees strong potential for capital appreciation, however. Acting on its medium-term tactical convictions, Pioneer is currently overweight equities, particularly those based in China, the euro zone and India; overweight the U.S. dollar versus the euro; and underweight the yen against the dollar and euro.
All investors who take high-conviction bets to boost returns are liable to be challenged by the argument that, particularly when it comes to the zero-sum game of investing in currencies, they are just as likely to be wrong and lose money as they are to be right and make money. Lombardo’s response: Pioneer always designs “well-diversified portfolios, which can adapt to a variety of market conditions by using various uncorrelated betas,” with no single beta dominating a strategy. This creates a series of natural hedges that prevent a particular view from having a negative impact if it proves to be wrong.
Lombardo also discounts the risks in Pioneer’s strong dollar position, noting that the greenback “can be played as an asset class but also used as a hedge.” He cites its status over the past three years as a hedge against long positions on global equities.
UniCredit and Spain’s Banco Santander announced in September that they were in talks to merge Pioneer with Santander Asset Management, with each bank to own about one third of the new company. Private equity funds General Atlantic and Warburg Pincus would own the remaining third.
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