Kelly Prior: The current search for income

As of 9 March, the UK Government is prepared to pay the grand return of 0.37% per year in interest for lending it money. The US government is offering a juicy 0.97% and the European Central Bank want investors to pay for this privilege.

To secure even theses rates through depositing cash in the bank would be a challenge. With inflation in each of these jurisdictions sitting somewhere around 2%, savers would in fact be losing money.  

As we grow older and need to rely more on the savings we have stashed away to pay us back for our patience in not spending them, the options to deploy this capital in a place that will pay us income without permanent loss of capital are ever diminishing.

The beneficiaries of the decade of de minimis interest rates have in the first instance been companies. The cost to borrow has fallen dramatically for them as yield hungry investors clamber to beat inflation.

The equity market price falls of the last couple of weeks have resulted in a boost to the yield in percentage terms for many companies globally. Just looking at the UK market stalwarts such as BT (10.8%), BP (8.2%) HSBC (7.5%), BAT (6.8%) are astonishing. We, however, are fund pickers and while these yields look attractive on a headline level, we prefer to rely on the skill of active fund managers to select companies that are best placed to analyse if the earnings that sit behind these dividends are safe and growing.

Montanaro

A reasonably recent addition to our income portfolios has been from the Montanaro stable of funds. Montanaro was established in 1991 - almost 30 years ago - by Charles Montanaro to offer investors access to Small & Mid Cap markets.

The firm has remained true to its roots over those years by exclusively focusing on Small & Mid Cap investing, though it has launched a number of funds and expanded its geographical investment remit in that time by moving from the UK to Europe to finally launching a Global fund in 2018. Importantly however, Montanaro has remained a private and independent boutique.

In terms of its investment philosophy, they are Quality Growth investors with a common sense approach. They will not compromise on quality, especially when it comes to management teams, and only invest in companies they understand.

They have one of the best resourced and experienced teams dedicated to their asset class in the industry but also enjoy being a close-knit team of 30 and appreciate the benefits of that, so do not want to grow any larger. The team have the time to conduct in-depth research on the companies in which they invest and do not rely on the sell side for ideas or research.

Their analysts instead are building all their own financial models from scratch. They believe it's worth paying up (within reason) for growth and believe in investing for the long term, so prefer a buy-and-hold approach to excessive trading.

Last year, we invested in both their UK Income and European Income Funds. Both the UK and European Income funds pay quarterly dividends with an expected yield of 3.4% for this year, with 50 and 54 holdings respectively. 

In March of 2010, the go-to fund of choice for UK Equity Income was run by one Mr N Woodford. The £13m Chelverton UK Equity Income fund wasn't getting much airtime despite a hefty yield and highly experienced team of David Horner and Dave Taylor at the helm - it was at this point that we invested and have remained with the fund to this day.

With a somewhat traditional business owner valuation mentality, they have spent the last 10 years seeking out UK domiciled "proper companies" that pay a 4% plus dividend at point of purchase. Positions are gradually reduced as they near the 2% yield marker at which point they are replaced. Granted, as they have matured and grown, they have crept up the cap scale and broadened their holdings base, but the yield on the fund has remained pretty constant at around 5%, as well as generating impressive capital growth.

Property

Another area of interest for us is specialist property. A good example of a favoured holding in this sector for us is Target Healthcare. Diversification has been increasingly difficult to come by in recent years as the correlation between asset classes has increased.

Quantitative Easing has pushed the cost of borrowing ever lower buoying Equities, while bolstering total returns for Bonds as the risk free rate falls ever lower. Property is an asset class that has traditionally complimented Equities and Bonds in income seeking mandates as while capital values are unexciting at best, the steady income stream provides ballast in more volatile times.

However, Property is illiquid as we know, so accessing it in the right way is crucial. We have preferred to use alternative vehicles when investing in this sector - with a focus on niche areas to counter the natural volatility that can influence the daily price of these investments. For example, Target Healthcare is a REIT that purchases only modern purpose built care homes, with a diversification in geography and operators but an uncompromising approach to quality.

The supply and demand dynamics for this sector are irrefutable, with NHS prioritising the need to reduce expensive "bed blocking" often caused by a lack of suitable longer-term arrangements for those that would be equally, if not more comfortable, in a care home. The vast majority of the market consists of older, converted buildings which are, on average, less efficient for residents to navigate and for staff to maintain so the benefit of purpose built facilities are clear.

Emerging markets

For more traditional income generation Bonds are a viable option. Emerging Market Debt through the Ashmore Emerging Total Return Debt fund offers sizable income. The mandate has full flexibility to invest across the full spectrum of emerging market opportunities to achieve total return through a combination of income and capital appreciation.

Emerging Market Debt total return enables investors to remain invested in all states of the world. They can shelter in dollar denominated bonds during Emerging Market currency weakness, position in local rates with low correlations with US rates during Treasury volatility and exploit spread tightening in corporate bonds if credit markets are strong.

Total return offers enormous diversification across 70 plus sovereigns, over 50 corporate bond markets and over 20 local markets and introduces an extra source of alpha from theme selection.

All three segments of total return offer compelling value. External sovereign debt pays 4.75% in USD terms. At nearly five-times US Treasury yield, this implies a favourable compounded return differential in excess of 20% over five years. Diversification insulates the asset class from idiosyncratic country risks. The spread of 370bps is 10 times greater than the credit risk premium suggested by historical default rates.

Emerging Market Corporate High Yield have six times lower default rates than US High Yield and lower leverage, yet still pay a greater spread. They have shorter duration than Emerging Market Sovereign Bonds and present the opportunity to trade local and global credit cycles.

Investors will increasingly want exposure to Emerging Market Local Currency Bonds as the Dollar loses steam. Investment grade and short duration, local bonds offer a largely virgin return proposition. Emerging market currencies are 20% cheap to the Dollar and bonds pay a positive real yield of more than 200bps. Investors can expect 26% return from interest alone over the next five years. With FX, the return rises to 50%, or 9.5% per year in Dollar terms.

By combining all three segments of Emerging Market Fixed Income, total return investors avoid the risk of missing out on opportunities in any one segment of the market. They can remain invested in all states of the world and thereby harvest the true benefit of investing in Emerging Markets, namely yield.

Kelly Prior is an investment manager at BMO GAM

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