Income portfolio with a difference

BOB'S PORTFOLIO

Source: Investors Chronicle. Price and value as at 15 March 2013.

LAST THREE TRADES

Infrastrata, Invensys and UK Mail

Chris Dillow, the Investors Chronicle's economist, says:

This portfolio is a good answer to the question vexing thousands of investors: how do we get a decent income when interest rates are so low?

Economic theory tells us there’s a problem with any attempt to do this. However intelligent - you can only earn higher returns than on cash by taking more risk. And this is just what you’re doing.

Here, however, we must distinguish two types of risk: normal risk and disaster risk.

The normal risk is the danger of everyday bear markets. Relative to many investors, you are not greatly exposed to this. Your equity portfolio has a large defensive weighting - I don't think your Alternative Investment Market (Aim) holdings add much to equity risk as they are lightly correlated with your other stocks - and your permanent interest bearing shares (Pibs) and preference shares help diversify equity risk still further.

But ordinary volatility is not the only risk. There’s also disaster risk - the small chance of things getting very nasty indeed. And you are exposed to this. For example, Pibs carry the risk of interest not being paid if building societies decide they need extra capital. This risk is magnified by liquidity risk; if investors, rightly or wrongly, start worrying about the societies' health, you might be unable to sell quickly, if at all. These risks are no mere possibilities: just ask those who bought Northern Rock or Bradford & Bingley Pibs.

This is a low-probability risk. But it’s a high-impact one. The sort of circumstances in which building societies need to raise capital would be ones in which even defensive stocks fall a lot, and in which preference shares suffer too, from a loss of liquidity and perhaps credit risk.

In this sense, you’re taking on tail risk. Whereas you’re tolerably well protected from the large chance of small mishaps, you’re more exposed to the small chance of large ones.

I do not say this to criticise you. It’s a brute, unavoidable fact that when interest rates are low good returns can only be achieved by taking on risk. The question is: are the risks worth taking?

For some people, they are not. In monetary terms, the one per cent chance of (say) a 30 per cent loss is equivalent to the 10 per cent chance of a three per cent loss. But for some people, these are not equivalent. Loss-averse investors want to avoid the former more than the latter. You, however, seem to be doing the opposite.

Two things, however, make me suspect this is a risk worth taking.

First, it’s possible - only possible - that loss aversion and disaster risk are priced factors. If loss averse investors steer clear of some assets which offer unusual amounts of downside risk such as pibs, then expected returns on them are higher for those investors who are not loss averse. If this is the case, then you are making decent expected returns, albeit in exchange for taking on a danger which others are avoiding.

Secondly, there might be a cognitive bias at play, causing Pibs to be unusually good value now. Because the collapse of some building societies looms large in our minds, thanks to bitter memories of Northern Rock and Bradford & Bingley, we might be over-estimating the probability of a repeat. If so, some investors might have shunned Pibs unnecessarily - in the same way that some people don’t fly after a plane crash. If this is the case, your Pibs have been a genuine bargain.

So yes, your portfolio exposes you to risk. But these might well be risks which are worth taking. And it is only by taking risk that you have a chance of a good income.

Ben Willis, head of research at Whitechurch Securities, says:

With interest rates at emergency levels and unlikely to be raised anytime soon, cash deposit rates are meagre and so investors are being forced to turn to other assets to generate better returns. As a pensioner, you have already identified this, opting not to buy an annuity, where income levels are low due to the current interest rate environment and low gilt yields. Instead, you have selected to generate income from a range of higher risk investments, which should have delivered solid returns over recent years.

You state that your attitude to risk is generally low but this appears contrary to your portfolio of investments, which consists of Pibs, preference shares, and equities. I would rate all of these investments as above average risk.

For example, Pibs provide an increased, attractive level of income. Yet they are essentially subordinated debt and are therefore higher risk than conventional bonds and unlike bonds they can stop payments altogether meaning income will be lost and the shortfall does not have to be made good when regular payments resume. Some Pibs also have the option to repay at a fixed date after which if they choose not to repay capital the interest can fall to a significantly less attractive Libor plus rate.

Furthermore, while preference shares are considered by many to be a safer option as the dividend is seen as secure it can still be cut. Holding preference shares can be notoriously difficult as the underlying structures are often complex with the terms differing from each share and investors need to be aware of the terms and conditions for each individual share as well as considering the liquidity for these shares should they wish to sell at any future point.

Amanda Tovey, head of equities at Whitechurch Securities, adds:

The equity content of your portfolio is split between preference shares, ordinary shares and funds. Looking at the sector breakdown of the preference and ordinary shares it indicates the portfolio is very concentrated in certain sectors with nearly 30 per cent in utilities companies, just over 25 per cent in financials and nearly 20 per cent in industrials. This concentration of sector risk should be considered as major changes within an industry such as regulatory changes within the utilities sector could have a major impact on a large percentage of the portfolio. It is also worth considering the similarity between companies and the markets in which they operate for example Balfour Beatty, Carillion and Babcock which are similar in nature and therefore likely to be affected by market trends in the same way. Ask yourself: is the portfolio really as diversified as I would like?

Overlap between direct holdings and shares held within a fund should also be considered, the New City High Yield Fund, which is currently yielding over 6 per cent, has some overlap between the shares held in this fund and the shares held directly within the portfolio such as the Balfour Beatty 10.75% preference shares. You need to consider if you are happy with this overlap and possible increased exposure to certain shares.

Ben Willis continues:

Your investment portfolio is tending to lack diversity, with several areas of concentration in your direct equity exposure which you may want to address. In addition, the PIBS and the preference shares are acting as a bond proxy, without really behaving as a direct substitute. However, from the risk perspective and looking at your financial position as whole, you do have £90,000 within a spread of building society accounts and £15,000 in Premium Bonds. These counterbalance your exposure to high risk assets, with an approximate. 50/50 split between cash and low risk holdings and the Pibs, preference shares and equity investments, resulting in a holistic risk profile that is below average.