The popularity of income-generating investments is potentially a source of trouble. However, this trend is different from what we’ve seen in the past: income investing can apply to any sector, as well as many different structures of investments—even those not traditionally associated with capital markets like annuities and insurance products. Previous mega-trends have been sector-specific, but any sector can pay interest, dividend or some other kind of cash flow.
How long will the trend last? And how popular will it become? The latter is important, since it helps determine if the trend will morph into a fad, then a craze, and finally, a bubble. For example, all but the most unabashedly optimistic were stunned during the height of the tech boom on the Nasdaq.
To analyze a trend, you have to pinpoint its source. This helps forecast how long it will last.
Demand of income-generating investments has a clear source: demographics. The largest cohort of the investing population has started to either plan financially for retirement, or is already in the process of retiring. In response, many of them are seeking income-bearing investments. The other part of this equation is people are living longer.
2. Risk appetite
After many years of punishing volatility, we look to risk appetites. The ills of the American equity markets have been felt in the Canadian equity markets as well. Housing prices in Canada are at or near record highs, but so is the amount of debt per household. These issues, plus the downturns of the last decade, have led people to avoid additional risks.
Risk appetites are in decline, and won’t bounce back for some time. While this applies particularly to boomers, who believe this could be their last chance to grow their nest egg, we’ve heard the same from much younger investors.
So, this begs the question: can an investment bubble be born out of fear and risk aversion? If investors are flocking to income-generating investments because they’re tired of seeing investments fluctuate wildly, and prefer to see a regular stream of cash flow even if it means limiting the upside of their accounts, can this turn into outright greed? Greed, and fear of missing out, are the final factors in the formation of any bubble.
While investors feel they’re taking less risk by tending toward income over capital gains, it doesn’t always work out that way. Government bonds and debt from investment-grade corporations have always been the domain of income-seeking, risk-averse investors. But yields on these products have dropped to such low levels that many are now choosing (or worse, are forced) to take on more risk by buying income securities of lower credit quality or much longer duration.
We’ve watched as investors have started to consider riskier bonds when looking for adequate returns. This applies to dividend investing as well. While stocks do not have implicit credit ratings from major agencies, the effect is the same as in the bond market. This has been going on for some time, but is not always dangerous. Much of higher risk investing activity is “normalizing” to the level of risk that people usually take.
Read: Bearing up with bonds
This behaviour over the long term can result in investors taking on more risk than is appropriate. An income portfolio can be every bit as risky as a growth portfolio when assembled incorrectly.
Let’s look at companies that are raising capital in the markets by issuing stocks, bonds, and preferred shares. Because of demand, issuing income securities has become a relatively cheaper form of financing for companies.