These two portfolios should give investors a £10,000 annual income

Our Money Observer £10,000 income challenge has beaten its income goal in both previous years. Helen Pridham introduces two new portfolios. 

Inflation, standing at 2.5 per cent for March, may be on the wane after peaking in November at 3.1 per cent – but it has not gone away, and it is potentially very damaging for investors. It will gradually erode the value of your capital and income, so anyone investing for the long term who needs a regular income really needs to look for investments with the potential to maintain the value of their capital and preferably grow their income payments as well. This is where some of the Money Observer Rated Funds can help.

The 2018 Rated Funds list includes a variety of funds and investment trusts designed to provide a regular income; many offer attractive yields in excess of inflation, with the prospect of future capital growth as well. They don’t provide the same capital security as a savings account, but if you can take a long-term view you will often be able to ride out the ups and downs in the stock market. In any case income payments tend to be less volatile than share prices. Indeed, there are some investment trusts that have been paying out a steadily increasing income for 50 years or more.

By combining several different types of fund and investing in different asset classes, you can also spread your risk and increase your chance of long-term success. Funds investing in shares are likely to produce the best income growth over time.

This year the UK’s top companies are expected to pay out higher dividends than last, according to the latest AJ Bell Dividend Dashboard. It forecasts that FTSE 100 companies will pay out a total of £87.5 billion in dividends in 2018, with the 10 highest yielders forecast to produce an annual yield averaging 7.9 per cent.

However, there is some concern about the future of UK dividends because the average cover for the dividends of the UK’s leading companies is lower than in recent years. This makes it even more important for income-seekers to have global exposure. The dividend cover (the number of times a company’s most recent dividend is covered by its earnings) for 2018’s ten highest-yielding blue-chips stands at 1.4x, whereas a secure dividend is generally deemed to have 2x cover.

Investing globally allows you to benefit from company profitability in other parts of the world. Global dividends also grew strongly last year, and after a surge in the third quarter the overall increase in 2017 was 7.7 per cent on a headline basis, according to the most recent Janus Henderson Global Dividend Index. It showed that there was underlying growth in dividends across every region and sector worldwide.

Choosing your risk level

However, it is also important to include funds in your income portfolio which specialise in other asset classes such as bonds and property, as they can help to stabilise your income and capital when equity markets fluctuate, and thus make your overall portfolio more balanced and less risky.

To demonstrate how you can put together an income portfolio, for the past two years we have used our Rated Funds list to create medium- and higher-risk portfolios designed to produce £10,000 of annual income. Most of these funds will pay income into your bank account at half-yearly or quarterly intervals, and some pay a monthly income. Each year we update the portfolios to reflect changes in the Rated Funds list.

The main difference between the two portfolios is that the higher-risk version includes more specialist funds with higher yields, which means the initial investment required to generate £10,000 of income is somewhat lower than for the medium-risk portfolio.

However, specialist funds inherently involve more risk. There are also five investment trusts in this year’s higher-risk portfolio, which means investors may see additional fluctuations as a result of changes in the difference between their share prices and net asset values – the premium or discount.

We have not created a lower-risk income portfolio, as we want to make it clear there is always some degree of risk when investing in funds; if you’re really not comfortable with the possibility of at least shorter-term capital losses, then you should steer clear of the stock market.

However, we hope and expect that our portfolios will generate some capital gains as well as income growth over the medium to long term. The box on page 26 provides more detail of how the portfolios fared last year, though of course it’s not wise to make assumptions about future returns based on past performance.  

The medium-risk option

The medium-risk portfolio includes two pure bond funds which make up nearly 25 per cent of the total investment. Bonds generate a steady income as well as giving capital stability to a portfolio, although their potential for growth is limited. However, the advantage of the Jupiter Strategic Bond and Marlborough Global Bond funds is that they both allow their managers to invest in any type of fixed income securities globally, so they can take advantage of the best opportunities.

The Kames Property Income fund is included in this portfolio to provide diversity, and it also offers an attractive yield. It was impacted less than some more London-focused property funds by the UK’s vote to leave the EU in June 2016, thanks to its policy of investing in smaller properties in the regions that offer good income streams.

Regular monthly payments are provided by Jupiter Monthly Income. This fund, as well as the newly added Seneca Global Income & Growth investment trust, are mixed asset funds. They invest in fixed interest securities as well as shares, so they help to give more balance to the portfolio.

Jupiter Monthly Income has a particularly well-spread portfolio because it invests mainly in investment trusts including overseas trusts, such as European Assets and Schroder Oriental Income. Similarly, Seneca benefits from a global spread, though currently it is nearly 50 per cent invested in the UK.

Our medium-risk portfolio also includes a core UK equity income holding, Threadneedle UK Equity Income, which is managed by Richard Colwell. An investment approach of seeking out ‘hidden gems’ has enabled him to achieve good results in falling as well as rising markets.

However, with Brexit looming on the horizon, we feel it is important for investors to have a good dollop of exposure to overseas stock markets. In addition to Artemis Global Income we have therefore added the JPMorgan Global Growth & Income investment trust to the portfolio. Unlike many similar products, both of these funds have less than 10 per cent of their assets invested in the UK, making them truly global.

They also have complementary approaches, with Artemis’ manager aiming to invest in companies with good dividend streams, while the JPMorgan trust invests mainly for capital growth, which is used to pay a steady quarterly income.

The higher-risk option

The foundations of our higher-risk portfolio are a UK equity income investment trust, City of London, and a fixed income fund, Royal London Sterling Extra Yield, which jointly make up nearly 30 per cent of the portfolio. Both are run by longstanding managers.

City of London holds the record for the investment trust with the longest run of annual dividend increases, stretching back 52 years. It invests predominantly in larger UK companies with typically around 60 per cent of the portfolio invested in FTSE 100 businesses, while the remainder is invested in medium-sized and smaller UK companies and some overseas firms.

The Royal London fund invests in a broad range of fixed interest securities, including investment grade, sub-investment grade and unrated bonds.

For additional spread this portfolio, like the medium-risk version, includes Kames Property Income, Seneca Global Income & Growth investment trust and Artemis Global Income, to provide exposure to other asset classes and global diversification.

The remainder of the portfolio is invested in three specialist investment trusts, which have been added to the mix to give more variation and greater long-term growth potential. It is important to note that all three of these trusts, European Assets, International Biotechnology and Invesco Perpetual UK Smaller Companies, are taking advantage of a rule which allows them to dip into their capital to boost their dividends. The advantage of this approach for income investors is that it gives them a way of gaining exposure to areas that do not necessarily generate high levels of dividends, where trusts are investing primarily for capital growth instead.

European Assets and Invesco Perpetual UK Smaller Companies both focus on medium-sized and smaller businesses. Historically, these companies tend to outperform their larger counterparts over the long term. With European economic growth expected to be ahead of that of the UK over the next two years at least, European Assets should benefit.

Meanwhile the emphasis of Invesco Perpetual’s managers on looking for quality companies with strong balance sheets and cash flows that can deliver growth independently of the wider economy, should help to provide protection against a post-Brexit UK economic downturn. International Biotechnology, the portfolio’s smallest holding, invests in a sector which can be volatile, but with biotech companies heavily involved in producing new drugs for the rapidly ageing populations in many countries, we believe it represents a promising long-term investment.

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