Fed up of poor savings rates? Here’s where to invest for income

The search for income is likely to become riskier as more normal conditions return to equity markets.

The financial crisis has changed the face of income investing. An era of ultra-low interest rates has been accompanied by low government bond yields – a combination that has caused investors to step up the hunt for yield.

For some investors, this has meant taking on more risk in the hope of securing a healthy income. ‘This has generally worked out okay, as volatility has been exceptionally low, but it is a strategy that is extremely vulnerable to a reversal in market conditions,’ says Andrew Wilson, chief investment officer of wealth management company Lockhart Capital Management.

The chase for yield has caused a range of asset classes that offer a reliable income to become expensive (as these investments are in high demand). This trend has persisted over recent years as the low interest rate environment has continued, so investors who are seeking to generate a healthy income in 2018 will once again have their work cut out.

We asked a number of professional investors to highlight where they are seeing the best income opportunities for the coming year across asset classes, markets and sectors.

Income growth potential

The prospects for UK dividends look positive for 2018, according to Nathan Sweeney, a senior investment manager at Architas Multi-Manager. He expects income growth will continue to be driven by the financial and mining sectors – a trend that was evident in Capita Asset Services’ quarterly dividend monitor. This showed that UK dividends broadly rose by more than 14.3 per cent year-on-year to £28.5 billion during the third quarter of 2017.

‘If you look at the total dividend payments that came out during the third quarter, about two thirds of them came from mining companies. There has been a big rebound on that side,’ says Sweeney. This came about because miners’ management teams have reined in their spending and are allocating capital better.

Nine years since the credit crisis hit, banks have also got their balance sheets in order and are gradually upping dividend payments. The Bank of England’s decision to raise interest rates by 0.25 per cent to 0.5 per cent in November – the first interest rate hike in the UK for 10 years – should also prove supportive for the sector. In theory, higher interest rates allow banks to increase their margins.

On the other hand, Sweeney notes that if interest rates move up too sharply, this can put pressure on the consumer and lead to defaults on loans, so it is a balancing act for central banks. Nevertheless, he notes: ‘Banks will benefit from higher rates initially and margins will increase over a period of time before people start to default.’

Banks in the US are already starting to benefit from multiple interest rate rises over the past few years, and Sweeney suggests profits could be boosted if the regulatory environment continues to soften under president Donald Trump. ‘It is difficult for Trump to get policies through Congress, but the one thing he can do is write executive orders to deregulate financials. He has the power to do that and he is doing that,’ Sweeney says.

In the UK, he pinpoints Majedie UK Equity and JOHCM UK Equity Income as two funds that are well-positioned to benefit from dividend growth in the oil and gas, mining and banking sectors.

UK small caps represent another sector where Sweeney expects to see dividend growth coming through in 2018, given that talented fund managers are able to back fast-growing companies with strong cash generation. He highlights the Chelverton Small Companies Dividend investment trust or the open-ended MI Chelverton UK Equity Income funds as two options to consider.

A new dawn for Japan

Although Japan isn’t a market that income-seeking investors would have targeted historically, reforms have encouraged companies to become more shareholder-friendly. Businesses are now starting to pay dividends and buy back shares.

‘The headline yield is low by international standards, around 2 per cent, but the potential for that to grow is really quite exciting. Over the past year or so, companies have started to be run for shareholders in a serious way,’ explains Daniel Lockyer, chief investment officer at Hawksmoor Investment Management.

‘Payout ratios had been low and companies had not thought about share buybacks or shareholders. It was just about investing in the business and holding cash back. That is definitely changing now because of corporate governance codes and new indices that have been set up, where companies are included if they have a certain return-onequity profile,’ Lockyer adds. He points to Baillie Gifford Japanese Income Growth, launched in July 2016, as a fund to consider in order to gain access to this theme.

Balanced income

For investors who are looking for a healthy income from their investments, as well as the prospect of capital growth, Sweeney suggests backing quality companies with solid balance sheets and stable dividend payments.

In the global equity space he cites Lindsell Train investment trust as one to watch, given its strong track record of holding companies that fit this criteria. However, as the trust currently trades on a 12.1 per cent premium to net asset value, it far from a screaming buy right now.

For investors who are seeking a balanced income from UK stocks, the investment manager suggests Threadneedle UK Equity Income, which yields 3.9 per cent. ‘It has been very consistent and has performed well over time,’ Sweeney adds.

Lockhart Capital’s Wilson highlights the benefits of the Asian income story, given that it offers diversification within a broader portfolio, access to fast-growing Asian businesses, and an attractive yield of 3.5 per cent plus.

‘Asian income stocks have lagged the technology-driven rally of late, but may be due some catchup, or at least will likely hold up better during a downturn. One might question whether now is the right time to be buying equities in general, but a long-term strategy here should pay off,’ Wilson explains. Prusik Asian Equity Income and Schroder Asian Income are two of his top picks in this space, with yields of 3.3 and 3.7 per cent respectively.

While some commentators complain that yields across parts of the investment-grade and high-yield corporate bond markets are low because prices look high (as the two move inversely to each other), emerging market debt appears to offer some value. ‘One yield-capture strategy is to simply sit in emerging market government debt and harvest the coupons,’ says Wilson.

‘You can get more than three times the yield offered by a UK gilt. However, you have to accept the currency fluctuations that come with an investment in local currency debt, albeit you might take the view that over the long term the prospects and fundamentals for emerging market currencies are better than those for sterling,’ he adds.

Investors who are not comfortable with currency fluctuations may feel happier buying a dollar-denominated emerging market debt fund, Lockyer notes. Emerging market debt allocations may also be appropriate for investors seeking a high income.

‘Emerging market debt gives you a 6 to 7 per cent yield from countries and companies that are less indebted than many other parts of the world. And they have currencies that are relatively cheap when you compare them to the lower-yielding, more indebted and vulnerable currencies in other parts of the world,’ Lockyer explains.

High income

In the ultra-low interest rate environment we find ourselves in today, investors who require a high income (for example to fund retirement) face a challenge. In the equity space, companies that pay out higher dividend yields tend to be slower-growing, mature companies.

‘There is nothing wrong with this, indeed there is evidence that a portfolio of these companies tend to outperform “growth” companies over the long term,’ says Peter Sleep, a senior investment manager at Seven Investment Management. ‘But there are long periods where low-dividend, growth companies do very well – like today, where the market is being driven forward by tech stocks,’ he adds. 

As a result, funds and investment trusts which target high-dividend companies have lagged the market over the past year. Although this may have been frustrating for some investors, Sleep anticipates a rebound could be on the cards in 2018. For those looking for exposure to global high-income stocks, Sweeney highlights the Murray Income investment trust as one to consider, pointing to its attractive yield of 4.3 per cent. Fidelity Moneybuilder Dividend is another good option in the UK equity income space, he says, with an attractive yield of 4.5 per cent.

Beware of the risks

As yields are low across parts of the mainstream fixed income market, investors are being pushed inadvertently to take on more risk to achieve a higher income. Barclays’ multi-manager Stephen Peters suggests keeping an eye on the potential risks associated with any investment that boasts a high yield.

‘Eight to nine years following the financial crisis, there isn’t much out there offering a high yield that doesn’t come with a high risk. For example, we saw a sell-off in one or two of the infrastructure investment companies. These offer high yields, but after political comments were made, prices fell,’ Peters explains.

Infrastructure investment companies have certainly experienced a fall from grace over the past year, after the Labour Party threatened to cancel hundreds of private finance initiatives if it were in power. This caused premiums to NAV to narrow significantly on two of the best-known funds in the sector, HICL and John Laing Infrastructure.

Ian Rees, Premier’s head of multi-asset research, agrees that investors must continue to monitor the potential risks associated with income assets. Fortunately, he says, selective opportunities remain. ‘One of the greatest risks is that a bubble is created amongst income-paying assets, given the hunt for yield most investors face. I don’t think we are facing these pressures yet,’ he says.

He highlights the Foresight Solar investment company as a high-income fund pick. It provides an attractive yield of 6 per cent from contractual revenues that are derived from solar generation.

Playing property

Open-ended property funds that invest in bricks and mortar attracted headlines for the wrong reasons during the summer of 2016. The Brexit vote sparked a wave of selling by investors, which put pressure on fund managers who were unable to sell properties quickly enough to generate the cash they needed to give back to investors. This resulted in six property funds suspending trading, while others imposed penalties of 10 to 15 per cent to discourage investors from withdrawing their money.

The majority of these funds had re-opened and lifted penalties within six months. However, the debacle highlighted the dangers of investing in an illiquid asset class that has economic and political sensitivity.

However, Lockyer says specialist real estate investment trusts (Reits) offer a good alternative. He likes Civitas Social Housing, LXI and AEW Long Lease. These all target yields of 5 per cent plus from care homes or social housing, which indirectly receive government support. ‘Whether they are care authorities or housing associations, you are getting quite a secure stream of income that is often linked to inflation as well,’ Lockyer adds.

Areas to avoid

Historically, investors have sought to capture yield by moving up the risk spectrum from government bonds to corporate bonds, and then into high yield. Today, Wilson notes that this poses a challenge because spreads – the difference between the yields from government bonds and those from corporate credit – have narrowed as prices have risen. ‘Spreads have contracted to such an extent that it seems barely worth taking the risk here. Corporate bonds are hugely expensive, and high-yield debt even more so,’ Wilson says.

It is also worth remembering that bonds can be sensitive to interest rate movements. Low interest rates and central bank bond-buying activity have caused government bond prices to rise and yields to fall. However, now that central banks are starting to raise interest rates and unwind quantitative easing, bonds appear less attractive. This is because bond prices could fall (causing yields to rise), resulting in capital losses.

The upshot is that investors are being forced to consider other parts of the bond market. Premier’s Rees, for example, points to the closedended Real Estate Credit Investments as a good option. It invests in real estate credit secured by commercial and residential properties across Europe, and yields around 6.6 per cent.

As we enter what Lockyer describes as the last stage of the bull market, he urges investors to keep a close eye on valuation. For this reason, he is avoiding US equities, which look richly valued. ‘For us it is hard to invest in areas that don’t have valuation support or a margin of safety,’ he concludes. 

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