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Is a 6 per cent yield at age 78 too risky?

Peter has a high-yield portfolio and wants to adopt the same strategy for capital from the sale of a buy-to-let property. Our experts warn that high income comes at a price

Peter is 78 and has been investing for 54 years. He says: "The interest rate situation has prompted me to seek a better income from the stock market. In large part due to the recommendations of the Porfolio Clinic, I have accumulated a portfolio of 13 direct holdings in company shares and investment trusts which are worth £73,000 and yield close to 6 per cent."

Peter's wife is selling a buy-to-let property to release capital that will be invested for income.

He says: "I deal with the overall management of the property and am finding the work involved a trifle taxing with tenant damage, dodgy drains and a right of way across the property, to the extent that we are seriously considering an imminent sale. This is despite an average profit over the last five years of £5,125 and, with likely sale proceeds after capital gains tax of £84,000, a yield of 6.1 per cent.

"I intend to suggest to my wife that she adopts the same investment philosophy as mine in investing the proceeds so that there is a minimum reduction in income. Is this too risky?"

Reader Portfolio
Peter 78
Description

Investment trusts & direct shares

Objectives

6 per cent yield

PETER'S HIGH-YIELD PORTFOLIO

Name of holdingValue%
Chesnara (CSN)£6,4209
National Grid (NG.)£5,7158
Vodafone (VOD)£5,4777
Merchants Trust (MRCH)£6,5359
Henderson Far East Income (HFEL)£5,1387
Royal Dutch Shell 'B' (RDSB)£4,3426
CQS New City High Yield (NCYF)£5,5778
M&G High Income Trust (MGHI)£6,6739
HICL Infrastructure (HICL)£6,1758
Berkeley Group(BKG)£5,6678
GlaxoSmithKline (GSK)£4,2816
European Assets Trust (EAT)£6,1858
BlackRock Commodities Income (BRCI)£5,4527
Total£73,637100

Source: Investors Chronicle, as at 18 May 2015

 

RISKS OF HIGH-YIELD STRATEGY

Chris Dillow, Investors Chronicle's economist, says:

Your unhappy experience with buy-to-letting reminds me of an important fact - that income comes at a price. Apparently nice rental yields are compensation for the risks of voids, bad tenants and the hassle of maintaining the property.

The point generalises to equities: here too, yield comes at a cost.

If one share yields 5 per cent and another 2 per cent, why would anyone prefer the 2 per cent stock? The answer is that the 5 per cent stock has some kind of disadvantage.

One is that it is riskier. In particular, some income stocks are cyclical; they tend to do especially badly in recessions. In 2008 mortgage lenders and builders had high yields - but this didn't stop them collapsing. You are taking on some of this risk not just with Berkeley (BKG) but also with BlackRock Commodities Income (BRCI). What's more, some of your holdings are correlated and so might do badly together: commodity stocks and emerging markets tend to rise and fall together, and Merchants (MRCH) and M&G's High Income (MGHI) trusts invest in similar assets: higher-yielding UK stocks.

The second disadvantage of higher-yielding stocks is that the market believes that they offer lower growth; investors need income now from some stocks because they fear they won't get so much of it in future years. Vodafone (VOD), GlaxoSmithKline (GSK) and National Grid (NG.) fall into this category.

If all this sounds like a case against chasing income, it shouldn't. There are two things in your favour.

First, your portfolio is a balance of cyclical stocks such as Berkeley and BlackRock Commodities and low-growth defensives such as National Grid and Glaxo. This makes it about as well-diversified as a 13-asset portfolio can be that is fully invested in equities.

Secondly, history tells us that - over the long run and on average - income stocks tend to do better than others.

One reason for this is simply that investors should be compensated for the additional cyclical risk they take - and on average they are. In this context, you are in a happy position. As a retired person, you have no risk of losing your job. You can therefore take recession risk more comfortably than younger investors and so you should be in a position to receive the risk premium from cyclical investing.

But there's a second reason why income stocks do well. It might also be that investors have too much confidence in their ability to foresee future growth and so become too pessimistic about stocks which they believe have gone ex-growth. To the extent that this happens, income stocks can be genuinely underpriced.

For these reasons, I actually like your portfolio.

However, even the best equity portfolios take lots of risk simply by virtue of being equities. A fall in the world market would hurt this portfolio. I would budget for a one-in-six chance of an annual loss of 10 per cent or more. Could you cope with this? If so, then fine. If not, then perhaps you should take the opportunity from the sale of your wife's property to simply put some money into cash savings. Yes, their income is low - but insurance comes at a price.

 

Alan Steel, chairman, Alan Steel Asset Management, says:

It concerns me when folks in their late 70s appear to be drawn to high-yielding strategies, equity linked, after a strong bull run over the last six years, a run that has seen yields fall in tandem, right across the board of equities, bonds, annuities and deposits.

Even in 'normal' times we caution that the higher the yield on any investment the greater the risk there is to capital or the lower the likely level of capital growth. Exceptions can involve recovery situations or new and/or smaller companies yet to develop a long-term track record. But they represent high risk to capital and income even in the best of times.

Older investors may have little or no time to recover from losses. Even a high-risk investor should be challenged on his/her capacity for loss. We've had a fair run recently, compared with history, without a significant correction (clever word for fall!) in stock markets generally, so the Law of Averages suggests one is overdue. The sensible thing for your portfolio may be to drip into your chosen investments over the summer. Collective funds would also dampen your risks.

 

Jason Hollands, managing director, business development and communications at Tilney Bestinvest, says:

We're living in a period where investment income is in scarce supply as a direct result of central bank policies to keep interest rates at record low levels and this in turn has led to yield compression across other asset classes. A 6 per cent yield strategy in the current environment is very demanding and rigid pursuit of it inherently involves being drawn into ever more niche investments which either risk significant capital volatility or limit the prospects for yield growth.

Tax tip: Use capital gains allowance

Mr Dillow says: You have an £11,100 capital gains tax (CGT) allowance. If you take all your returns as income, you risk not taking full advantage of this.

Mr Steel says: Aiming for a 6 per cent-plus yield at this point in the cycle outside rented property is too risky. We would trim back the yield target and aim to make up the difference with capital growth - likely but clearly not certain. With generous CGT exemptions these days, using capital encashments year by year makes sense because they'd be tax free in this case.

 

CURRENT HOLDINGS

Mr Hollands says:

With almost 80 per cent exposure to equities and a number of these trusts being geared, this is a fairly high-risk portfolio.

You have too much exposure to commodities as a result of the combined holdings in BlackRock Commodities Income (BRCI) and a direct holding in Royal Dutch Shell (RDSB). But Shell is also the largest holding in Merchants Investment Trust and the M&G High Income Investment Trust and a large holding in the BlackRock Commodities IT, so you should cut this position.

While the oil price has moved off its lowest point earlier in the year, a subdued oil price could well remain a feature of the market for some time yet as the Saudis seem prepared to sustain the pace of output in an attempt to hammer the US shale oil industry. A loosening up of western sanctions on Iran tied to a deal over its nuclear programme could also see a step up in oil production, exacerbating a market destabilised by oversupply.

The outlook for the broader commodities markets also look challenging with some evidence from recent data that global growth is stalling and, in particular, China continuing to transition its economic model away from debt-financed and commodities reliant construction projects towards developing the Chinese consumer and service sectors.

We have cut commodities exposure to zero in our own managed portfolios.

HICL Infrastructure (HICL) is one of your more conservative investments, providing access to a portfolio of operational Private Finance Initiative projects under very long-term contracts. Like other listed investment companies providing very dependable income streams, it trades at a very large (14 per cent) premium which means there might be some risk of capital losses once interest rates and bond yields rise. That's unlikely to happen this year but it is a factor to be aware of.

Merchants is a UK blue-chip focused investment trust with a middle of the road overall track record, but the benefit of a high yield for those prioritising immediate income. M&G High Income Investment Trust invests in many of the same companies, predominantly drawn from the FTSE 100. The outlook for dividend growth in the FTSE 100 has, however, become more challenging, with the oil and gas companies facing pressure from sliding prices, the banks reeling from fines and the supermarkets seeing margin pressure from discounters.

Even GlaxoSmithKline (GSK), a long-standing favourite income stock for many fund managers (and a holding in both Merchants and M&G High Income) has seen its dividend cover weaken. You might consider cutting the direct holding to GlaxoSmithKline.

Netherlands-domiciled European Assets Trust (EAT) is a mid- and small-cap focused investment company. It has performed well under the management of Sam Cosh since 2011, and has done particularly well over the last six months as European equity markets anticipated the initiative of a QE-stimulus programme, which is now in place. European equities should continue to benefit from this support. Additionally, low energy prices are very constructive for the western European economies which are major net importers of oil and gas.

 

Mr Steel says:

Given where we are after a 30-odd year secular bull market in sovereign bond yields, we recommend caution towards fixed interest. While we don't think interest rates will move up quickly - more slowly slowly catchee monkey - any upward pressure on them will cause capital to suffer losses. We would be cautious of existing fixed interest holdings M&G High Income Trust (MGHI) and CQS New City High Yield (NCYF).

 

SUGGESTED NEW HOLDINGS

Mr Steel says:

Funnily enough 'the best of times' isn't obvious at the time, and is usually seen as such in hindsight. Applying that logic, given that small/micro caps have had a dismal run over the last year or so, this could well be the time to nibble away at the sector. Gervais Williams has a decent record in income stocks at the smaller end of the spectrum.

You hold FTSE stocks Glaxo, Shell and Vodaphone, but even the big boys can cut their dividends as BP and others have shown. Sarasin Global Higher Dividend (GB00B850BN01), a low volatility fund with a decent yield of 4.4 per cent, is a safer long-term option for you.

Your portfolio appears to have a fair degree of risk which ought to be diversified. You and your wife may wish to consider two key areas that look attractive now in terms of income yield: property investment trusts and infrastructure trusts.

Ediston Property Investment Company (EPIC), run by former Standard Life's Danny O'Neill, offers a 5 per cent yield and the prospect of capital growth. Target Healthcare REIT (THRL) offers modern facilities to the very elderly and its tenant operators underpin a 5 per cent-plus yield with inflation protection.

Among infrastructure funds, Greencoat UK Wind (UKW) yields over 6 per cent and has some government underpinning with agreed income subsidies. Contracts are long and while residual value is uncertain there's a hefty premium over gilts and deposits. Nextenergy Solar Fund (NESF) also targets a 6 per cent yield in the renewable sector. It seems to be an investment sector the sun is shining on favourably, you could say.

Funds lending to both sectors also have some appeal. GCP Infrastructure (GCP) and Real Estate Credit Investments (RECI) both have strong loan books, and offer 6 per cent yields.

The strong performance at Royal London Sterling Extra Yield (IE00BJBQC361) may be a decent alternative in the fixed interest space.

These suggestions would give a weighted average yield of 5.5 per cent, offer diversification and some modest prospect of capital growth.

 

Mr Hollands says:

Medium-term earnings growth and dividend growth prospects look better among the more domestically-focused mid and smaller companies parts of the UK market - a trust which plays more in this space is the Standard Life Equity Income Investment Trust (SLET). The yield is 3.8 per cent but the dividend growth prospects may be stronger and it is trading at a 7.7 per cent discount to NAV.

One missing asset class in the portfolio is commercial property, which has attractive income characteristics where the tenant quality is good and the leases robust. Closed-end investment trust companies across this space are trading at premiums - among these Picton Property Income (PCTN) (yielding 4.6 per cent) is more modest.