• The US Federal Reserve is likely to keep rates higher for longer, supporting more defensive positioning
  • The interest rate cycle may already be turning in certain parts of Latin America
  • It is a buoyant year for income seekers, with a wide range of options and a better environment for ‘value’ companies

2022 was an extraordinary year for income in the Americas. As Latin American central banks and then the US Federal Reserve (‘Fed’) raised interest rates, financial markets saw a major adjustment that changed the landscape for income investors. In bond markets, there was a significant rise in yields, in stock markets, ‘growth’ areas came under pressure, while ‘value’ areas thrived.

With 2023 well underway, the process of adjustment is largely complete. Investors continue to speculate about a potential Fed ‘pivot’ that would see them ease their tightening policy. If anything, that pivot may be even closer in Latin America, where central banks were quicker to rate rates in response to the inflationary threat.

Fran Radano, manager on The North American Income Trust, believes a shift in policy remains relatively unlikely in the near-term: “We disagree with the market, which is expecting a Fed pivot in the second half of this year. We believe the central bank will keep rates at a higher level. It doesn’t want to make another error by cutting too early and keeping inflation around.”

In contrast, Latin American central banks may be on the cusp of change. Viktor Szabo, manager on the abrdn Latin American Income Fund, says: “We’re close to the end of the cycle. In most countries, the adjustment has already happened. There may be more hikes in Columbia and Mexico, but we’re already seeing rate cuts being priced in in Brazil, where inflation has dipped below 6%.”

Market impact

Radano has a defensive tilt to the North American Income portfolio. “We’re not looking at sector bets, but within each sector, we’re looking at the more defensive companies.” He believes higher interest rates will push investors to look more closely at valuations. “When the cost of capital is negative and companies have unlimited ability to tap capital markets, valuations don’t matter quite as much, but with the Fed Funds rate at 5%, investors care about profitability once again.”

He believes the value rally seen in 2022 can be sustained: “We don’t look at last year as a single year bounce-back for value managers.” He points out that in spite of the outperformance of value companies last year, their relative valuation remains low. Growth companies still appear highly rated, even where their outlook is uncertain: “I’m not sure the market is pricing in a recession and multiples are on the high end. This is why stock selection is very important,” he adds.

For Szabo in Latin America, the decision is more nuanced: “We’re in an interesting part of the cycle. Growth is coming down. There are still fears of global recession, though that may have been overblown. Inflation has peaked all round. Our response has been to add duration to our bond portfolio and to rotate away from being long equities to holding more bond exposure.” Today, the portfolio is split 64% equities to 36% debt. 

Income outlook

The outlook for income is buoyant in both the US and Latin America. Radano admits there is greater competition for capital now. He says: “With higher quality bonds yielding 5-6%, a dividend portfolio is yielding 3-3.5%, so it would be naïve to think there wasn’t competition. However, ours is a growth and income fund. We have limited exposure to ‘bond proxy’ areas, with much of our portfolio growing income at high single digits or more. We have a progressive dividend policy, and should outpace inflation over time.”

He adds that with a portfolio of 35-40 companies, he is a position to focus on their balance sheets, cash generation and conversion. “If I had to worry about my 67th best idea, it’s a different conversation. But the way we look at companies helps - we had one dividend cut during the pandemic and it was small. The trust has reserves of over a year’s worth of dividends.”

In Latin America, yield is abundant. The yield on a 10-year Brazilian government bond is currently over 13%. The dividend yield on the MSCI Latin America Index also looks high relative to history, at over 9%. Szabo says there are some distortions. “The energy sector now has extremely high dividend yields, at around 15%. The yield on our portfolio is lower because we have less exposure to those energy companies. In particular, we have reduced exposure to companies such as Petrobras because we’re concerned on political interference. The real estate sector also has high dividend yields and we have less exposure to that.”

Szabo’s team has the same security selection process employed across all of abrdn, which focuses on the strength of the balance sheet. “In Latin America, central banks have a history of changing rates, and companies have been through many cycles. It’s nothing exceptional for them.” For the trust, however, the fixed income side does the heavy lifting on income.

From both Szabo and Radano, politics remains a concern for the year ahead. Both are hoping for a more benign environment than seen in 2022: Latin America has had to digest multiple elections, while the US has had to deal with the mid-terms. Radano says that there are concerns, particularly with the debt ceiling, while Szabo says Peru may be politically turbulent in the year ahead. “We’re hoping for a boring year,” he adds.

2022 was a year of significant adjustment. While the stock market still has to face down significant challenges, the prospect of a more certain interest rate environment and weaker inflation should be beneficial. In the meantime, it is a better environment for income investors than it has been for many years.  

Important information

Risk factors you should consider prior to investing:

  • The value of investments and the income from them can fall and investors may get back less than the amount invested.
  • Past performance is not a guide to future results.
  • Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
  • The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
  • The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
  • The Company may charge expenses to capital which may erode the capital value of the investment.
  • Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
  • Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
  • There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
  • As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
  • The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
  • Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
  • With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
  • Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

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