Income products: The next bubble?

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.

Read: Income solutions for everyone

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.

Read: When bubbles burst, clients suffer

To analyze a trend, you have to pinpoint its source. This helps forecast how long it will last.

1. Demand

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.

Read: Coping with aging clients

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.

Read: Lessons learned from Lehman Brothers and Are you at risk?

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.

3. Companies

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.

For this reason, many companies will pay higher dividends than would normally be warranted by business conditions, or issue more debt than they should because it’s cheap. There is evidence of the former. The dividend yield on the TSX is higher now than it was in 2005, despite interest rates being much lower. The prime rate in Canada was between 4.25% and 5% in 2005, but only 3% today.

Read: Dividends remain the smart play

While it may lower their cost of capital, this leaves a smaller cushion in the form of retained earnings for companies to rely on if business conditions get tough. This can be seen by comparing the average payout ratios of dividend-paying companies in the TSX now and 10 years ago (see “Average payout ratios,” below). Indeed, we’ve seen many companies issue more shares rather than cut dividends to avoid upsetting investors.

Average payout ratios of dividend stocks have risen significantly

Source: Macquarie Private Wealth

4. Income Hybrids

Income hybrids are securities like structured products, notes and closed-end funds. We have seen an explosion of these products in the past few years.

While many of these are great solutions for income seekers, this is often the area where investors can get caught purchasing unsuitable investments. Scrutinize these securities beyond the typical business conditions and management capability required for traditional stocks and bonds. Structure, liquidity, derivatives counter parties and fees all matter.

5. Capital Gains

If the rush toward income securities (particularly dividend-paying equities) continues, the price of those equities will keep rising. Even investors with higher risk tolerance who aren’t focused on income could view the sector as a path to capital gains. Already, the safe portion of the TSX has outperformed the cyclical and risky portion for more than a year (see “Riskier stocks,” below).

Riskier, cyclical stocks have underperformed income and safe stocks

Source: Macquarie Private Wealth

A rush of this nature would typically start slowly, and indeed may have already started in the higher rated, lower-yield sectors of the market. Many investors buying government bonds are doing so as a vehicle for gains rather than yield, making it difficult to determine if one sector has gotten too hot.

While the seeds of a bubble have been sown, that doesn’t guarantee that one will form. So advisors must be cautious. The universe of income investments is so large that investors should be able to satisfy their needs without taking on excessive risk.

It will be hard, however, to choose the right investments alone given the number of bonds, REITs, preferred shares, dividend-paying stocks, debentures, funds, closed-end notes and structured products already in the market. Add to this their rates of growth, and you’ll need solid research and an experienced income team behind you.

James Price is director of Fixed Income with Macquarie Private Wealth in Toronto.