Why the ‘natural income approach’ pays dividends

James Mee examines options available to income-oriented investors in the current environment.

A natural and intended consequence of quantitative easing following the global financial crisis has been the reflation of asset prices. Trough to peak, the global equity market has climbed 210% and the S&P 500 has risen by an extraordinary 350%.  

For holders of traditional asset classes - equities and bonds, the past 10 years has been one of the most extraordinary bull markets in recent times. The best 10-year rolling performance for a traditional 60% equities/40% bonds portfolio over the past 30 years was the decade running to July 2019.

The net effect of this asset price reflation has been to lower yields available to investors almost across the board. At the 2009 equity market trough, the yield available on the S&P 500 was 3.65% and is now 1.9%.

The MSCI AC World yielded 4.25%, now 2.5%, and as mentioned, developed government bond yields have fallen precipitously. In September 2019, $17 trillion (£13 trillion) worth of bonds (government and corporate) were trading with negative yields.

Whatever the reason, the net result for an income-oriented investor is lower available income for the same level of risk as was available 10 years ago. Options are available to income investors, but each has its limitations.

The first option is for the investor to take more risk in order to achieve the same yield. For example, to achieve the same 4% available on UK and US 10-year government bonds in 2008, today one must invest in BB bonds in the UK, and BB- bonds in the US – both “high yield” and higher risk than sovereign investment grade debt, with a higher risk of default, and higher loss given default historically.

Similarly, equity investors could hold more cyclical names with high-dividend yields, but perhaps less visibility of income through the cycle. Or, they could invest in the same defensive names, with more visibility but lower dividend yields, and add leverage, thereby increasing the income yield on capital invested. We hope that the limitations with this approach are obvious.

A second option open to the high-income investor would enable them to avoid taking such risks. They could accept a lower natural income (that is, the income derived solely from portfolio holdings), and supplement it by selling a portion of invested capital to pay out as income. We term this “taking income from capital”.

By paying income from capital, however, the portfolio is significantly less able to compound returns over time, meaning that while a short-term risk of loss may be mitigated, long-term capital growth opportunities shrink.

To give you some numbers on the effect of paying income from capital, assume that a portfolio pays a natural income of 3.5% but an investor demands 5% from the portfolio and therefore has to sell 1.5% of invested capital per annum in order to achieve this (5% - 3.5%). Then assume that the portfolio generates a total return of 2% per annum. Over a 30-year period, the capital growth will be 16%.

Now assume that one pays only the 3.5% natural income received and does not therefore have to sell capital. Over the same 30-year period the capital return is 81%. So, for a 60-year-old retiree with an investment portfolio of £100,000 this is the difference between a £116,000 portfolio at 90, and one of £181,000.

The third – and our preferred – option is to remain invested and receive only natural income. The obvious limitation is clearly that the income yield will be lower than the other two options.

However, there are also benefits. By not selling capital to fund income, an investor’s portfolio is able to compound over time. Not only will this be beneficial to a portfolio’s capital value, but also to its income: as the capital base grows, the income received will also rise.

Total return (capital growth plus income received) over the same period would be 128% for the first and 194% for the second example; £128,000 versus £194,000.

Additionally, by not “reaching for yield” (i.e. taking more risk), investors limit the risk of permanent capital loss and/or a loss of income, as lower-quality businesses cut dividends (or default in the case of bond holdings). It is important to invest in businesses that will pay income through the cycle, not because of it.

Our intention is to ensure that capital invested is worth at least the same in real terms in 10, 20, 30 years’ time. We want to avoid reaching for yield, and thus ensure sustainability of income through the cycle; we want to get paid through the cycle, not because of it.

James Mee is manager of Waverton Multi-Asset Income Fund.

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