Fishing for better income

Caspar Rock, CIO of Architas Multi-Manager, explores the different options for investors wanting to boost their income.

Investing solely for the purpose of capital appreciation has left many investors nursing their wounds of late, as most asset classes continue to experience significant volatility. Total returns on investments should not be limited to capital growth and ought to include an income element.

Cash

Saving deposits have provided income to risk-averse investors for decades. However, research now highlights the derisory rates currently on offer: half of the 1,200 savings accounts available in the UK pay 0.5% or less, and one in four pays only 0.1% or less – which equates to £1 a year for every £1000 saved.

Furthermore, rampant inflation continues to erode cash’s purchasing power. The UK consumer price index hit 3.7% in December, close to double the government’s 2% target. Were we in the midst of an economic upturn, such a high number would have led to the consensus calling for a rise in the UK base rate.

The following week, however, it was revealed that the UK economy unexpectedly contracted by 0.5% – economists expected a 0.4% rise – causing the consensus to become less ‘hawkish’ in their interest rate expectations. Savers are effectively caught in an unattractive cocktail of currently high inflation, low interest rates and weak economic growth.

Bonds

Gilts and corporate bonds are a logical progression for the investor in search of income. However, yields on both have fallen over the last two years for very different reasons. Income from corporate bonds has declined as a result of the improving macroeconomic backdrop and healthier balance sheets in the private sector. Spreads (the premium received for holding corporate bonds compared to government debt) widened sharply following the demise of Lehman Brothers in September 2008.

These spreads narrowed swiftly in 2009 once investors realised there were hefty gains to be made by buying corporate debt where the market was pricing in too high a risk of defaults. Investment grade debt was one of the stellar asset classes in 2009, and according to the IMA, the Sterling Corporate Bond sector attracted almost £1 in every £4 of retail money.

2010 was a different affair after investors realised that most of the easy money had been made the previous year through buying ‘oversold‘ asset classes. The sector became less popular as investors searched for other more risky or less oversold assets. In our view, most of the easy money in the corporate bond market has now been made and although returns were positive in 2010 they were nearer what would normally be expected from the asset class.

Since 2009, gilt yields have been lowered artificially through quantitative easing. However, as result of a recovery in economic growth, a pick up in inflation and inflationary expectations, yields on ten-year gilts have risen since the third quarter of last year and now yield 3.82% (at time of going to press) from a low of 2.82% at the end of August.

Government bonds as an asset class should continue to face the headwinds of an economic recovery and a normalisation of the yield curve as some of the more unconventional measures such as quantitative easing that were introduced during 2008-9 start to unwind.

Property

While residential property recorded a modest low single digit rise in 2010, the shift in sentiment which engulfed many risk assets spread to the commercial property sector. The asset class grew by 14.5% over 2010 according to the Investment Property Databank (IPD), the benchmark commercial property index.

The nascent recovery saw investors return in numbers to commercial property funds toward the end of 2009 – yet we can now only describe the sector as fair value. The shift in allocation may have been premature as the UK commercial property market in 2010 saw a deceleration of capital appreciation over the first half of the year before growth rates weakened to a near standstill over the final six months.

Nevertheless, the underlying income yield on property remains reasonable but the significant inflows into open-ended funds that invest in physical property has meant the cash levels in these funds is causing a drag on yields, and there is greater competition for properties.

Multi-asset

Mixed asset funds, tailored to include an allocation between stocks, bonds and alternatives, are designed to provide both income and capital appreciation whilst attempting to reduce the level of overall portfolio risk. Spreading investment risk should increase the probability of achieving an attractive and less variable level of income over the long term. Different assets tend to exhibit varying behavioural patterns over economic cycles as shown in the table below. Whilst financial markets invariably suffer set-backs over the short term, investing with diversification should help reduce the probability of a severe portfolio loss as well as reducing the volatility of the income.

An efficient way to increase diversification is to ‘fish from a bigger pond’ and select funds with a broader investment objective whilst retaining an income bias. These have distinct advantages – there is a large and varied range of companies and non-traditional asset classes in both developed and emerging overseas markets where dividend yields and dividend growth rates are higher than in the UK.

Many UK equity income funds suffer from high concentration and overlapping holdings, as ten companies produce nearly 65% of the total dividend income in the UK. Moreover, in the UK, only five listed companies have delivered 25 years of consecutive dividend increases compared to nearly a 100 in the US.

Sectors such as the IMA Cautious Managed require a minimum of 50% of assets denominated in sterling or euro, enabling investors to more fully benefit from geographic and currency diversification. Sector classification restricts these funds to include a maximum equity exposure of 60%, coupled with at least 30% invested in fixed interest and cash. The sector also provides investors with the flexibility to invest in alternative assets.