Income investing

Overview 

Income funds can play an essential role in your overall investment portfolio. Their purpose is to provide a consistent and predictable income stream from a portion of your overall portfolio where capital preservation may be needed.

It is, therefore, imperative for investors to be clear about their chosen fund’s expected return path and to understand the risks the fund will take in order to arrive at that return profile.

The challenge is that:

• the investment universe for fixed income funds is complex, much more so than that of equities;
• not all income funds are of equal risk and thus return; and
• there are many fund options of which the return profiles vary greatly.

This edition aims to demonstrate why investing in income funds with a proven track record of delivering through various interest rate and market cycles, supported by a team with depth in terms of skills and experience, are key to delivering on the risk and return objectives for this conservative component of investors’ portfolios.

What is an income fund and what return profile can you expect?

The classic definition of an income fund is one that aims to meet the needs (i.e., risk and return objective) of an investor seeking a conservatively managed fund that aims to outperform cash, or traditional money market funds, by 1-2% through the cycle, while aiming to preserve capital over the short term (typically 12 months). As such, investors will find income funds sitting somewhere between a money market fund and a bond fund on the risk/return spectrum.

The most popular type of income fund over the past decade has been managed income funds housed in the ASISA – Multi-Asset – Income category. These portfolios can invest in a wide variety of assets, such as cash, bonds, listed property and even equities, with the primary objective of maximising income on behalf of investors. The category allows for a high level of flexibility, with portfolios being able to invest as much as 45% offshore, 10% in equity and 25% in listed property.

One of the consequences of an increase in demand for this type of fund has been a wider (and less homogenous) set of available options compared to a decade ago, resulting in a much wider risk profile (and increasingly varying investor outcomes) as is clear from the graph below.

Finding the right income fund for your needs

To help make it easier for investors to end up in the right income fund that meets their desired risk and return profile, we’ve amended our fund range over the past year by:

1. Enhancing disclosures to help investors understand the risk taken to achieve the funds’ desired return. These improved disclosures include:
   
   
   
   
2. Calibrated our income fund range to the needs set of investors by launching Coronation Active Income Plus that has the freedom to invest in opportunities beyond the risk profile of a traditional managed income fund, but still aims to preserve capital over a 12-month period. We also launched a traditional income fund called Coronation SA Income that aims to provide a high yield from domestic fixed income assets only.

OUR RANGE OF RISK-PROFILED INCOME FUNDS

Our range of income funds include four actively-managed multi-asset class funds – our flagship managed fixed income fund Coronation Strategic Income and its offshore equivalent Coronation Global Strategic USD Income, as well as the more recent additions Coronation Active Income Plus and Coronation SA Income (that invests in SA assets only).

All four funds were born out of the same principles of capital preservation in the short term (over rolling 12-month periods), coupled with a strong focus on risk management whereby we never take more risk than is required to deliver on the funds’ stated return profiles.

Relative to Coronation Strategic Income, the following visual demonstrates how the two newer funds are expected to differ in terms of duration and listed property as well as offshore exposure.

In turn, Coronation Global Strategic USD Income is expected to have an average duration that doesn’t exceed three years, and listed property exposure of no more than 10%. The fund is suitable for investors seeking an intelligent alternative to US dollar bank deposits and wanting to utilise their offshore allowance in a conservative manner.

How our income funds achieve their return profiles

We apply the following fundamental principles to deliver on the stated risk and return objectives of our range of income funds:

1. ROBUST PORTFOLIO CONSTRUCTION

As with equities, we believe we can add value to conservative investors in our income funds through bottom-up security selection when assets are mispriced.

Our approach to asset allocation within the local and global fixed income universes mirrors that of the broader Coronation investment team, but the process needs to be overlaid with certain constraints given the needs of our income fund investors. These constraints include allocating to a blend of assets that:

• can deliver on our income funds’ respective performance objectives;
• while prioritising capital preservation over 12 months; and
• providing liquidity to investors with immediate income needs (such as those drawing a regular retirement income).

The following visual demonstrates the process in a bit more detail:

2. PLACING CAPITAL AT RISK

The reality is that in order to outperform cash over the long term, we need to take risk within our income portfolios. However, we never do this at the expense of our capital preservation commitment, or if it puts the fund at risk of underperforming cash (also see point 3).

So we set out to put capital at risk according to the following guardrails:

Taking considered interest rate (duration) and credit risk where appropriate

The following visual explains how we take considered interest rate and credit risk, where appropriate, across our income portfolios.

Actively managing our exposure to alternative sources of return when the likelihood of outperformance is high

To achieve our internal performance targets of cash plus 1.5%, 2% and 3% over the long term, one could argue that it is as simple as constructing a portfolio comprising only of instruments that offer yields in excess of cash.

However, allocating to alternative sources of return that offer protection and diversifying qualities requires careful analysis of the prevailing market environment and then to dynamically adjust exposure when the likelihood of outperformance changes as detailed in the visual below.

3. AVOIDING EXCESSIVE RISK FOR CERTAINTY OF RETURN

As part of our disciplined portfolio construction process, we never aim to increase our income funds’ risk profile or performance by increasing the possibility of investor downside.

This means that we won’t attempt to deliver more than the stated return target if we believe it will put our capital preservation commitment at risk or if it will result in us underperforming cash (see chart below using our flagship classic income fund Coronation Strategic Income as example). To achieve this, we use quantitative modelling to arrive at a blend of assets that allows us to meet our risk/return target with a high degree of certainty. As is also clear from the graph below, Coronation Active Income Plus is skewed more aggressively, resulting in a wider range of outcomes.

How our classic income funds delivered on their return profiles

DON’T EXPECT A LINEAR RETURN SERIES

As explained before, the need to put capital at risk through the portfolio decisions means that our income funds will not have a linear return series like that of a money market fund.

Over short measurement periods, performance can fluctuate. However, we will never position our income fund portfolios towards a single outcome. Instead, we create portfolios that comprise a diversified set of assets and always take a conservative approach to risk (e.g., through option protection strategies).

Sometimes, in the short term, these funds cannot deliver on their cash plus targets. Rising interest rate environments make it more challenging to provide cash plus returns. When rates are falling, it becomes easier to achieve this goal. However, we are confident that we can consistently deliver on the funds’ cash plus targets through the cycle.

A broad and deep team supporting these return profiles

Our fixed income team of 9 specialists is well-resourced and fully integrated into our global investment team of 54 professionals (see below). These specialists provide vital inputs to extract maximum value across the potential return enhancers in the fixed income universe. The team covers instruments both locally and offshore. And to enhance the rigour of our investment process in this universe, we share dual coverage with our respective local and global equity teams of the local and international credit issuers held within our portfolios.

EXPERTISE THAT CULMINATES IN DESIRED OUTCOMES FOR CONSERVATIVE INVESTORS, BOTH LOCALLY AND OFFSHORE

Our flagship domestic income fund, Coronation Strategic Income, consistently outperformed cash over its almost 23-year history, as shown in the graph below.

Equally, its global equivalent Coronation Global Strategic USD Income produced returns ahead of US dollar cash over its almost 13-year track record.

Conclusion

This edition explained the complex nature of income investing and the challenges involved in choosing a fund that meets your needs from both a risk and return perspective.

To help investors in this regard, we made some enhancements to our income fund range and demonstrated the fundamental principles we apply to our funds to arrive at their stated risk and return objectives. And as demonstrated in the long-term track records of our two flagship income funds, Coronation Strategic Income and Coronation Global Strategic USD Income, this approach has created significant value relative to local or US dollar cash over multiple decades.

Disclaimer
SA retail readers