The current global climate is creating a conundrum for anyone in search of income opportunities, says Francis Ghiloni
There's no doubt about it ' income investors are facing a challenge on a number of fronts and have been for some time. Lower interest rates, the deteriorating outlook for profits growth and market turbulence are all conspiring to provide those on the income hunt with a bit of a headache. The only upside, it would seem, is that inflation remains in check.
For investors who have traditionally sought income from equities, the global slowdown is not good news. Dividend levels have been falling (See Table 2) and look set to fall further as the outlook for corporate profits continues to deteriorate. A number of high-profile profit warnings have been issued over the past few months, particularly in the US. These have contributed to concern surrounding the outlook for the US economy and resulted in market volatility.
Various analogies have been used to highlight the importance of the US economy to global output. Some say when the US sneezes, the world catches cold, others have pointed out that when an 800lb gorilla falls over it tends to cause 'collateral damage'. The US itself accounts for 22% of global output. Together with the second biggest world economy, Japan, it accounts for 30% of global output. Growth in both of these economies has all but stalled.
The fall in dividends that is resulting from lower profits growth compounds the situation caused by the Government's decision three years ago to withdraw the ACT tax credit on dividends. The tax credit was available to tax exempt funds like pensions schemes, charities and Peps (prior to the launch of Isas) and its withdrawal has meant that the value of dividends to these funds has decreased significantly.
But instead of FTSE companies declaring larger dividends to try to make up the shortfall caused by the loss of the tax credit, they have tended to look at other ways of providing short-term shareholder value. For example, there has been a significant increase in share buybacks in the UK.
The emphasis has very clearly shifted away from large dividend payouts and income funds that aim to produce a good level of income through equity investment alone are finding it increasingly difficult to achieve their targets. This said, some equity sectors do continue to produce a higher yield than others and these are highlighted in the table to the left.
The conundrum facing equity income funds is that if they focus on this narrow band of sectors in order to achieve their target income, the quality and diversity of their equity portfolio can be compromised and the capital risk increased.
This is not hugely appealing at a time when market volatility has made many investors wary of investing in equity funds at all. If anything, those who continue to invest in equities are likely to be looking for even greater returns on their investment than before, given the increased risk they perceive they are taking.
Bearing all this in mind, you get the feeling that recommending a corporate bond fund to investors isn't as hard a sell as an equity fund at the moment. It's quite clear that bonds will become an attractive option in the current environment, not just to investors seeking income, but also those seeking to diversify or avoid equity exposure altogether.
It could certainly be argued that on a risk/return basis, bonds come out considerably better than equities at present. Standard deviation is a reasonable proxy to use for volatility. In the three years to 30 March 2001, the FTSE All-Share shows a standard deviation of 4.10 compared with the FTSE-A British Government All Stocks (Lipper corporate bond benchmark) standard deviation of 1.24 over the same period. The lower the figure, the lower the volatility.
Add to this the fact that in 2000, the FTA UK gilt all-stocks index returned 9.8%, while the total return on the FTSE All-Share was -5.9%, and you can see that a good story is building. The same trend can be demonstrated overseas. Over the last 12 months to the end of March 2001, the Merrill Lynch Treasury Master Index has returned 11.9% against a decline of 21.7% in the S&P 500 Index. Indeed, even on a three-year horizon, bonds have outstripped equities, returning 22.7% against 9.4%.
In the early part of 2001, the relative outperformance of bonds has continued. While the sharp slowdown in the US economy has had an obvious and spectacular effect on equity markets, it has also given bond markets another day in the sun. But we are talking total returns here ' what about the income challenge?
The income gap
Table 2 highlights the gap that has developed between the average levels of income generated by equities, and those generated by gilts over the past five years. From this, you can see that it is generally widening in favour of gilts, while corporate bonds offer a higher yield still.
Over the 12 months to the end of March, the average gilt income was £59.06 on £1,000 invested, while the average income generated by the FTSE All-Share stocks was £22.46 (source: Lipper, offer to offer, net income withdrawn).
All this is despite the fact that interest rates have been decreasing, which has put a downward pressure on bond yields. High demand for bonds has also helped keep prices high and yields relatively low. Whether or not the US will slip into recession remains the key question for the rest of the year. But the jury is still out and this uncertainty will continue to be reflected in equity market volatility to the benefit of bonds.
One thing that does appear certain, however, is that inflation looks as though it will stay low, protecting bond prices. Central banks proved last year that they would be as concerned about too much growth as too little, and would raise base lending rates accordingly. But the outlook is for low inflation and low interest rates.
While this puts added pressure on bond fund managers seeking to sustain generous levels of income, the increased yield gap that has developed in favour of bonds over equities looks set to be maintained for the foreseeable future.
Additionally, supply of underlying government bonds into the market continues to be very low. Strong economic growth and prudent fiscal policy means governments don't need to issue debt.
While the world remains a volatile place, low supply, ongoing demand for income and controlled growth suggest a bright future for bonds.
l Times are hard for income investors with lower interest rates and market turbulence.
l The only upside is that inflation remains in check.
l Low supply and ongoing demand for income suggest bright future for bonds.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress