How to invest for income

Income investors have a number of choices – gilts, corporate bonds, property or equities. There is also choice in the type of fund you use to invest. Let’s consider the options.

Bonds

The bond, or ‘fixed income’, sector offers various options.

Gilts

Gilts, also known as ‘government bonds’, are effectively an IOU to the government. As it is unlikely that the government will default on its debt, these are generally deemed less risky than corporate bonds.

Government bonds have historically been seen as a safe haven as they provide a regular income and a known level of capital return.For many investors, this capital certainty has helped to offset the uncertainty of stock market returns.

However, the outlook for gilts has changed dramatically in recent times, giving investors cause to think again about the trade-off between risk and reward. This is largely down to soaring demand for gilts. Between March 2009 and July 2012 the Bank of England’s monetary policy committee authorised the purchase of £375 billion of assets, primarily gilts, under its quantitative easing programme as a means of injecting liquidity into the economy.

At the same time, income investors have flocked to gilts amid the so-called ‘flight to safety These two factors have created huge demand for gilts, pushing prices up to record levels and gilts down to the lowest levels since records began (yields fall when prices rise and vice versa). It’s unsurprising, then, that many commentators see little value in gilts at present – and some have predicted a bubble in the gilts market that will leave investors nursing heavy capital losses when it pops.

McDermott says: “Government bonds once offered risk-free returns; now they just offer return-free risks. They are giving next to nothing in terms of current yield on 10-year bonds and just a 1% rise in interest rates would lead to a 9% capital loss on the gilt index. If yields return to normal levels quickly, the potential capital losses are quite frightening.”

Inflation is still a threat unless you buy index-linked gilts (where both income and the redemption price rise by inflation). Modray says: “The break even (relative to conventional gilts) rate of RPI inflation on 11-year index-linked gilts is about 3%, so if you believe inflation will average more than this over the next 11 years they could be worthwhile, although returns may still lag the best fixed rate cash savings accounts.”

Corporate bonds

Lending money to companies, as opposed to governments, involves a step up the risk scale. The riskier the company, the higher you can expect the rewards to be. For example, in early 2013 the redemption yield on bonds issued by multi-national consumer goods business Unilever redeeming in June 2017 was about 1.485%: the company was seen as being about as safe as the British government. An Enterprise Inns bond redeeming in December 2018 was yielding around 6.519%, suggesting investors were less confident in its financial stability.

Modray says: “If you sell a bond before redemption you might make a profit or loss depending on its price, which tends to be affected by interest rates, inflation and the company’s financial position. High inflation and interest rates are bad news, because a bond’s income is fixed, and vice versa. “

The golden rule when investing in bonds is to try to understand how much risk you’re taking. While high yields look tempting, they’re high for a reason.” McDermott recommends going for a strategic bond fund: managers of these have the ability to invest anywhere they like in the fixed-income sector. “Stock-picking is key,” he says. “Strategic bond funds are investors’ best bet because of their flexibility and ability to manage interest rate and credit risks.”Fahy believes that bonds should be seen as a “short-term diversifier, not a long term [income] solution”. He adds: “Our analysis shows that in the last ten years a typical investment grade bond fund has cut its payout by around 26%. “At some point bond markets are going to roll over and down, and with it the idea that bonds can be a reliable source of income: they never are through a long retirement!”

Emerging market bonds

Emerging market bonds offer a good yield of around 5-6% – a very attractive proposition in the current environment. They are far from without risk, though. Even although most emerging market bond funds are predominantly invested in government bonds, McDermott urges investors to view these in the same way as high yield bonds. He recommends the Investec Emerging Markets Local Currency Debt fund. “It’s a solid fund with the added benefit of local currency; I believe emerging market currencies will appreciate over time so this will add to returns for UK investors,” he says.

Property

Property funds are another way of achieving an income and can add another layer of diversification to your portfolio. Commercial property investments, such as offices, factories and shops, tend to have a good track record of paying a decent rental income and, barring recessions, rents also tend to rise longer term, making commercial property a good antidote to inflation.

In the last two years, however, income has contributed the lion’s share of returns in the sector, with property values tumbling. “Yields aren’t bad at the moment at around 3-5%, but I don’t expect much growth in the next few years,” says McDermott. “There are some concerns over rental growth, with some people expecting it to fall. Managers are, therefore, skewing their funds to areas of the UK where they expect rents to hold up better.”

The only practical way to invest smaller sums into property is through a fund. Fund managers will often take annual charges of 1.5-2% from income, plus you’ll indirectly pay around 4% in stamp duty when you buy into the fund as property funds must pay this when buying UK property.

With the residential property market remaining gloomy, Modray advises would-be buy-to-let investors to “drive a hard bargain when buying to reduce the likelihood of sitting on a loss in a year or two”. He adds: “Longer-term you’ll probably be fine provided you project the rental income will turn a profit after all initial and ongoing costs, but I’d avoid buying to let using a mortgage: any future interest rate increases could crucify your profits.”

Equity Income

Fixed income funds have proven popular in recent years amid a bull run in bonds, but equity income funds – those that invest in companies which pay dividends – often offer better yields as high-quality companies with resilient business models are building cash balances and returning larger amounts to investors in the form of dividends.

Against this backdrop, it’s unsurprising that a growing number of investors are turning to the stock market in their quest for yield. “If investors want long-term income, where growth in that income is vital, they must embrace equity income,” says Fahy at FundExpert.co.uk. Let’s take a look at the opportunities:

UK equity income

Dividends are doing well in the UK at the moment, says McDermott at Chelsea. “I’m much more in favour of equity income funds [than bond funds] just now,” he says. “Ten years ago the yield on a company’s bond

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was higher than that on the same company’s equity. Today, the opposite tends to be the case. Companies are sitting on a lot of cash and are looking after shareholders in the form of dividends.” Let’s consider some dividend yields. At the start of 2013, shares in Severn Trent, the water company, had a yield of 4.4%, while pharmaceutical giant AstraZeneca was yielding 5.8% (after basic-rate tax, which can’t be reclaimed).

McDermott tips the Threadneedle UK Equity Alpha Income and RWC Enhanced Income funds, while Tim Cockerill, head of collectives research at IFA Rowan Dartington, likes Artemis Income.“This fund is a classic equity income fund,” says Cockerill. “The majority of holdings are large cap and top holdings include BT, Legal & General, Vodafone and AstraZeneca – perhaps not exciting businesses but ones which are very solid and have predictable earnings.”

Fahy recommends funds that have shown strong payout growth over the longer-term. Schroder Income has grown its payout 41.6% over the past decade, while JOHCM UK Equity Income has increased its payout in six out of the seven years since launch. Of course, investing in the stock market means taking another step up the risk scale.

Modray says: “Share prices can be volatile, even for fairly pedestrian companies, so a sharp downturn in share prices could leave you sitting on a loss despite potentially attractive dividends. And there’s no guarantee dividends will be as high as expected or even paid at all if a company hits hot water.”The diversification afforded by investing in funds helps to mitigate this risk. Cockerill says: “If you dissect an equity income fund it will consist of, say, 50 holdings. Investors are always fearful of losing all of their money, but this simply won’t happen with an equity income fund because all 50 companies won’t go bust. “The fund will rise and fall in value as the stock market changes from being bullish to bearish and back again, but if investors are invested for the long term then they can sit back and ride out the ups and downs.”

Global equity income

The picture is similar in Europe and elsewhere around the world: companies have been cautiousamid the global economic crisis and, instead of making acquisitions or spending profits, they have been building cash balances which they are now using to pay dividends to shareholders. Global dividend funds give investors more diversification and there has been growing interest in this asset class over the past year, albeit from a low base.

Cockerill says: “Not so long ago the UK market was the best source of dividend income, but in the last ten years a change that began slowly has accelerated and equity income is available around the world. “This is really good news as it means investors can diversify away from the UK, where dividend income has become concentrated (by total value) into a small number of stocks. “Globally well-diversified portfolios can be constructed which generate an income that’s no different to one invested exclusively in the UK.”

McDermott tips the M&G Global Dividend fund, while Cockerill and McDermott both like Newton Global Higher Income.“In a world which is increasingly globalised and where there are more and more dividend-paying companies overseas, this is also a very good long-term investment if you want income,” says Cockerill.

Emerging market equity income

If you are happy to take on a bit more risk with the promise of greater rewards, why not consider emerging market equity income funds? Recent data shows that 90% of emerging market companies now pay dividends and there are at least 830 with a dividend yield of more than 3%, according to Chelsea Financial Services.

Fahy says: “There are roughly seven times as many dividend-paying stocks globally and we believe Asia is the gem. Asian companies are significantly better placed to grow dividends than their UK counterparts.” He likes Newton Asian Income, while Cockerill favours the Aberdeen Asian Income Investment Trust – two of only three Asian income investment trusts. “Aberdeen is quite cautious in its approach to investing – a strategy that seeks out quality companies with strong cash flow and sustainable dividends,” says Cockerill. “The capital performance of the trust has been exceptionally good and I would expect this to continue longer-term.

Source: www.marketviews.com