Low interest rates have reduced the options for income seekers of late but, says Cherry Reynard, although bonds are not offering much in the way of yield there are still equity income and cash-plus funds to consider
It's been a well-repeated cry over the past few years - in a climate of low interest rates, what is the best way to generate income? If investors are to venture beyond a bank account, they need an incentive. Should investors be looking to bonds (government or corporate) or equities for their long-term income provision? What does each provide in terms of risk and reward? Or are the new breed of cash-plus funds the answer?
In the long-term the risk/reward picture is clear. Corporate bonds offer a higher level of income for less risk to capital. Traditionally, the average investment grade corporate bond will offer a coupon in the region of 1% to 2% ahead of the yield on the equity market. It will also offer greater stability of income - the coupon level is set for the term of the bond. Overall risk comes from a clear combination of interest rates, inflation and default risk.
That said, equity income also has a lot to recommend it, particularly over other types of equity. Tony Nutt, manager of the Jupiter Income Trust, says: "If you look at the long-term returns of markets, not only in the UK, but also worldwide, it is the dividend that drives returns. Long-term returns are not governed by expansion in price/earnings (P/E) multiples, which rises and falls with market sentiment as was shown in the late 1990s."
Of course the risks are greater and the income is generally lower than that of corporate bonds. Investors get an equity risk premium for a reason, and dividends are cut regularly while bond coupons are not. But Nutt believes it is all about how much he is paid to hold a stock. Nutt quotes the famous statistic that over the past 200 years, 5.5% of the 7% average annual growth in markets has come from dividends rather than capital growth. Equally equity income has generated higher returns overall over the long-term.
However, there is good and bad income and it requires skill to negotiate the minefield. Errol Francis, manager of the Credit Suisse Growth & Income fund, says: "Stocks have high yields for two reasons. One, because growth options are limited. This would incorporate things like tobacco or utilities, where companies generate a lot of cash, but because they are not growth markets, companies don't invest and the cash comes back to shareholders. Two, is that they are 'recovery stocks'. For example, at the moment, Kingfisher is yielding more than the market, despite being traditionally thought of as a growth stock. Income investors will often be looking at the lower quality end of the market."
All this is fine over the long term. But advisers are currently facing an unusual situation in the bond and equity markets that will affect their decision on how to generate income in their clients' portfolios, even once the individual client's risk tolerance has been assessed.
Firstly, bond yields are at historic lows. Bond markets are extrapolating low inflation out for 50 years - while there is nothing (except perhaps the oil price) to suggest this scenario will change, it gives limited upside and a lot of downside. Laurence Mutkin, head of fixed interest strategy at Threadneedle says: "Traditionally, bonds have had less capital risk and investors have done rather better than the income stream - they have got capital appreciation too. But now 30-year gilt yields are at an historic low. There is a thought among investors that bond yields have to rise - many are surprised that they have stayed as low as they have for so long."
Mutkin says he can make a case for bond yields remaining low. After all, the factors that have driven them down - a fall in inflation expectations and increased institutional buying of fixed interest - are still in place. But in the short term those investing in corporate bonds are likely to get the income and nothing else and may even see some erosion of capital. Nutt says: "Potentially, in the short term we could envisage a situation where investing in corporate bonds posed a greater risk to capital than investing in equity income, but not in the long-term as corporate bonds rank higher when it comes to debt versus equity."
Equally, with equities yielding around 3% and investment grade corporate bonds yielding 4%, the income differential between the two is at a historic low. Equity income is not facing the same problems. Francis - in line with much of the market - believes equities remain good value. Equity income investing is naturally contrarian. If a share price rises too high, the dividend falls as a percentage of that share price and the stock ceases to be deemed 'high yielding'.
But equity income investing takes discernment. Peter Lowery, a manager on the Investec Cautious Managed fund, believes that the current popularity of income makes high yield investing more dangerous than in the past. He says: "I would argue that what has actually worked in the past has been investing in relatively unloved parts of the market. Yield has historically been overlooked and its followers have been rewarded. With the market now focusing on income I suspect that it's a more dangerous place to be."
Cash-plus funds have offered an alternative in this debate. Barings brought out its Directional Bond fund, DWS its Ratebuster and Threadneedle is planning a new launch this month. Aberdeen recently declared it will close the RateBuster fund, but this is more because Deutsche Bank was to be managing the fund rather than a reflection of the success of the product, which raised £60m during its launch period.
All these funds are part of a new breed of 'portable alpha' products. They aim to generate excess returns from the bond and currency markets for savers wanting the security of cash. RateBuster, for example, offered to pay 3% over base rate. Mutkin says: "Cash rates are higher than bond rates. These products offer a bond market return plus a bit of alpha." These products use derivatives and investors must have faith that their investment manager is a careful custodian and proper risk manager.
None of these options is a panacea. Many investors have been brought up to expect a 10% income for little risk. That era is over for the foreseeable future. Bonds have little to recommend them at current levels, except as part of a diversified portfolio. Despite a lot of recent articles about the increasingly good value of growth stocks, equity income still has much to offer. Cash-plus funds are an interesting new entrant, but advisers may feel safer waiting to see whether they deliver on their promises.
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