In pursuit of income: investigating the opportunities

Posted by Liz Rees in Portfolio management category on 24 Mar 16


Budget

Introduction

Many of us depend on a decent income from our investments to make our lives more comfortable, especially in retirement. This blog looks at where to find respectable sources of income in an environment of low interest rates, low inflation and relatively low global growth. We have not reviewed the rates available on cash (these can be found on comparison websites) but it is prudent to keep enough money aside in easy-access accounts to cover several months’ outgoings. However, other than providing a secure home for your money many deposit accounts have failed to offer returns in excess of inflation thus reducing the value of capital in real terms.

Not all income is the same

Income can be taken in the form of interest, dividends or capital gains. Equities pay it in the form of dividends while bonds pay interest and the historic percentage yield (on the basis of the last full year’s payment) that a fund has returned can be found on the provider’s factsheet. These income streams may be subject to different tax rules if held outside tax wrappers (i.e. an ISA) so you should consider which is most appropriate for your personal circumstances. Remember to choose income rather than accumulation units when making your fund selections if you want your income paid out to you on a regular basis. Another thing to bear in mind is that income streams can be uneven; most funds pay out dividends twice a year, some quarterly and a few monthly.

Where’s all my income gone?

Following the global financial crisis in 2008 Central Banks around the world aggressively cut interest rates and implemented Quantitative Easing (QE) programmes which involved buying in government bonds with the aim of reducing yields and reviving economic growth. The process has come to an end in the US and is near completion in the UK but is still actively underway in Europe and Japan.

Consequently, the returns from cash deposits and Government bonds have fallen sharply in recent years, in some cases to all-time lows. Downward pressure on inflation, largely due to a collapse in oil and commodity prices since 2014, has compounded the effect. Several experts have expressed concern that the long bull market in bonds may have come to an end. However, there are still some attractive yields available on corporate debt and overall default rates are not expected to rise significantly. Some investors have turned to equity income funds for better yields on their capital but economic growth has been slow to respond to the stimulus, holding back the performance of many equity markets.

Which sectors are offering the best yields at present?

We now provide a brief overview of different asset classes and their income generating characteristics, including Fixed Interest, Equities, Property, Commodities and Alternatives. In forthcoming blogs we will explore the main features of each sector and the type of funds available in more detail. You can use our tools in Fund Space to filter funds available by your required level of yield and the areas in which you wish to invest. Don’t forget to choose income units if you want your income paid out rather than reinvested.

Ideally, income seekers should aim for a secure and rising income stream which offers protection from inflation and preserves capital.

Fixed interest

It is possible to buy gilts or bonds directly but deal sizes tend to be large so for simplicity and liquidity most investors chose a fund.

Money market or cash funds are at the lower end of the risk spectrum for the sector and invest in cash or near cash instruments, including short term fixed interest securities. Nevertheless, they do not guarantee preservation of capital and charges can make the returns unattractive.

UK Gilt funds invest at least 95% of their assets in high quality (AAA rated) government bonds (gilts) while UK index-linked funds hold top rated UK government index-linked securities. Funds can react to the threat of rate rises by employing short duration or absolute return strategies* but these tend to produce relatively low yields, albeit superior to those available from cash. 

Corporate bond funds invest mainly in sterling denominated corporate bonds with a credit rating of BBB- or above. Global bond funds offer diversification across different geographical markets. High Yield bond funds usually offer a superior income to corporate bond funds because they invest in higher risk assets with lower credit ratings and hence a greater risk of default.

Strategic bond funds adopt an unconstrained approach without the restriction of a benchmark. They invest across different types of fixed income assets with the flexibility to switch their allocations according to where they see the most value at any time. This strategy improves the funds overall diversification and liquidity.

Obtaining a healthy yield without suffering any loss of capital has become more difficult as the fixed interest class has started to anticipate interest rate rises and the potential risk to capital. Bond yields will move up in response causing their prices to fall. However, as long as interest rate rises are gradual, experts do not expect a dramatic sell off in government bonds.

Furthermore, government bonds can be useful for protecting portfolios from market turbulence. For example, when equity markets experienced a correction at the beginning of this year government bond prices rallied, partly due to their safe haven status and partly due to expectation that interest rate rises may be deferred. Corporate bonds, particularly those with lower ratings and higher yields, show greater correlation with equities.

Equity income funds

Equities usually offer better inflation protection than fixed interest but tend to be subject to greater volatility, or risk, thus exposing your capital to greater gains or losses. To qualify for the IA Equity Income sector funds must have a yield in excess of 110% of their benchmark index.

The performance of equities is usually inversely related to interest rates. This may explain why in recent times equity funds have seen strong inflows as investors seek a better return than they can get on cash savings. Conversely, when rates are high some investors may decide not to take the risk of the stock market. Moreover, if higher rates coincide with a pick-up in inflation which devalues future earnings this can also have a negative effect on equity markets.

It should be remembered that high equity yields can be a reflection of mature, low growth businesses. Over the long term a company that grows its dividend consistently can provide more income than a company that offers a high dividend yield which grows more slowly. UK Equity income funds have traditionally been very popular with income seekers but with a raft of dividend cuts being implemented by many Blue Chip companies some investors have been looking overseas; for example in Europe where attractive yields are available or Japan where dividend pay-out ratios have scope to increase. Of course this can bring an added layer of currency risk which could be partially mitigated by opting for a Global Income fund.

In the current low yield environment there has been a notable rise in demand for multi asset funds, which may aim for a target income yield, and many have been launched recently to service the ‘at retirement’ investor. For example, LGIM have recently added 3 new multi-index income funds to their range. Another income producing strategy is found in ‘Income Maximiser’ funds (Fidelity and Schroders offer these) which use derivatives to capture extra income. The downside is you are giving away some of the upside potential of underlying investments thus reducing the chance of preserving or growing your capital over time.

Specialist

Specialist sectors can offer reasonable yields, including Commodities and Emerging Markets funds which tend to be at the high end of the risk spectrum.

Alternatives

Property is an alternative asset class which can provide an attractive source of yield. It also offers diversification as it does not usually correlate closely with the other main asset classes. Although many people think they have enough property exposure through their home, property funds provide exposure to commercial property which encompasses the office, retail and industrial sectors.

There are 2 types of property funds, those investing in direct property (bricks and mortar) and those which invest in indirect property (property shares). Direct property can be less liquid and in the past funds have had to be suspended if a lot of investors wish to sell at the same time, whereas indirect property is more correlated to the fortunes of the stock market. Global property funds offer investors additional diversification.

Other mainstream alternative assets include hedge funds, venture capital and infrastructure. Even more specialized examples are: art and antiques, precious metals, leasing and fine wines. The best way to access these sorts of investments would be through a multi asset fund and we will describe these in detail in a future blog.

Other categories for income seekers

Areas such as P2P lending, Structured Products and Buy to Let can be complex and are beyond the remit of this piece so you should take specialist advice before proceeding. We hope to carry out further research into the first two of these in the future and will communicate our findings.

Investment Trusts

Investment Trusts are closed end funds many of which offer attractive yields. They have the advantage of being able to retain up to 15% of income in reserve when dividends are plentiful in order to be able to maintain their pay-outs in more difficult economic times.

Don’t be driven by income alone; total returns matter

Even when income is your prime consideration it’s important to consider potential total returns. If you need to draw more than the natural income yield on your investments then you could see the value of your capital eroding over time unless the fund value grows strongly. Therefore, it may be worth considering some exposure to equity growth funds which can provide a source of income without diminishing your capital. Although the income from such funds is lower there may be greater opportunity to achieve capital gains and realise profits from time to time. This approach has the added advantage that any gains can be offset against the £11,100 capital gains tax allowance.

The contribution of growth in income is often overlooked but for long term investors it can be significant. Mature companies with low growth prospects tend to pay out more of their cash flow as income while those with good growth prospects reinvest cash flow to fund further growth.

On the other hand, if dividends exceed your requirements it may make sense to reinvest them as this can make a big difference to the value of your investment over time due to the power of compounding. According to the 2015 Barclays Gilt Equity Study, if you had invested £100 in the UK stock market in 1945; it would have been worth £9,148 in real terms (taking inflation into account) by the end of 2014. But if all the dividends earned had been reinvested, the total value of your £100 would have multiplied to almost £179,695.

How do I put together an income generating portfolio?

In general, the higher the expected return on an asset the greater the volatility, or risk and this applies to both income and capital expectations. Higher risk options tend to offer variable income, for example dividends on shares. Thus, diversification across a range of asset classes can spread the risk by providing blended exposure to Government and corporate bonds, equities, property and commodities according to your risk appetite, goals and time horizon.

Decide how much income you need to draw and when. Funds pay out income on either a monthly, quarterly or annual basis so by using investments with a range of different payment dates you can spread your income more evenly through the year. However, try not to take more than you need at once as you may miss out on valuable investment returns.

Don’t forget the tax implications

Remember to use tax wrappers such as ISAs and SIPPs to ensure you take the maximum possible income free of tax. If you earn income investments outside the tax free limits consider whether it would be more efficient to pay the tax on your income or to sell down some capital and incur Capital Gains Tax instead.

You may be happy to run down your capital or you may wish to preserve it to leave some to your beneficiaries when you die. As pensions can now be left to beneficiaries with favourable tax concessions it may be advantageous to first draw on other savings which might be subject to inheritance tax before dipping into your pension pot.

Conclusions

Bonds were the traditional source of income for retirees but with retirement lasting much longer these days the average retiree could have 30 years plus in drawdown so may need to take more investment risk to ensure their pensions lasts a lifetime. Therefore it could make sense to have a balanced portfolio providing income and growth from a number of sources. Tempting as it may be, try to avoid being driven by income alone as a high yield can mean high risk, for example a dividend cut for equities and default for bonds.

We may think it is only retirees who are seeking income but in fact it should also be an important consideration at other stages of our life. For people at the early stages of their investment journey, it is important to reinvest as much income as possible as this can have a huge impact on your future overall returns.

* Absolute return strategies aim to minimize volatility and deliver a positive return regardless of market conditions. This may mean they outperform in falling markets but underperform in rising markets.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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