Generating income from investments is only getting harder as the coronavirus crisis progresses. Link Asset Services has predicted that UK dividends could fall by between 27 and 51 per cent this year, with the recent Royal Dutch Shell (RDSB) cut proving to be just one example of a wider trend.
If investment trusts with revenue reserves offer some solace, even some of these are struggling to pay out the income they originally planned to.
Some 26 investment trusts had already deviated from their original dividend plans so far this year as of early May, with the vast majority of these focusing on income-generating alternative asset classes such as property, debt and leasing. These include BMO Commercial Property Trust (BCPT), Marble Point Loan Financing (MPLF) and DP Aircraft I (DPA), which have suspended their dividend payments. Others have cut their dividends.
Meanwhile investment trusts focused on seemingly more durable sources of income, including UK equities and infrastructure, have seen their shares trade at elevated levels due to investor demand.
This means that if investors want any income they may need to consider a wider range of assets. And one asset that looks more attractive from an income perspective at the moment is bonds. These had been a popular source of income, but have become increasingly expensive after a decade of quantitative easing has pushed their prices up. Bond yields, which move inversely to their prices, collapsed, making them unattractive to many income investors.
However, following the recent sell-off, the yields of some corporate bonds have returned to more attractive levels. Even though these yields fell again in April as markets recovered, they are still much higher than they had been. For example, US high-yield bonds, on average, yielded around 5 per cent at the start of 2020, and this shot up to nearly 12 per cent during the sell-off. Their yields were still above 7 per cent at the end of April, in contrast to US investment-grade debt, which had an average yield of around 2.5 per cent at that time.
Corporate bonds could be attractive for both growth and income investors. “When we were entering 2020, credit looked pretty fully priced," argues Tihana Ibrahimpasic, a multi-asset research analyst at Janus Henderson Investors. "You had to go down the quality curve to get decent return potential. Some of the yields we are now seeing are attractive. Fixed income has almost gone back to playing its original role in a portfolio of being a source of income.”
After April's calm, equity and bond markets could return to heightened levels of volatility. But fixed income markets are benefiting from expanded central bank bond buying programmes. In the US, the Federal Reserve has expanded its bond buying programme to the corporate bond market. This was initially limited to investment-grade debt, or higher-quality corporate bonds. But the Federal Reserve has since extended this to include riskier parts of the market via purchases of high-yield bond exchange traded funds (ETFs). Central banks in Europe and the UK have also ramped up their bond buying programmes.
Richard Dunbar, head of multi-asset research at Aberdeen Standard Investments, believes that investment-grade credit, in particular, is benefiting from this. “Looking to high-quality credit can get you a decent return,” he explains. “We are investing in areas where central banks are investing alongside us.”
No silver bullet
Corporate bonds once again look like a decent source of income. As the chart below shows, some funds ranked in the Investment Association Sterling Corporate Bond, Sterling High Yield, Sterling Strategic Bond and emerging market debt sectors are now offering extremely high yields. A high yield alone is not a reason to invest in a fund, but these figures indicate what is available.
However, bonds come with their own problems and are far from risk-free. Investment-grade corporate bonds do not offer yields of a comparable level to those traditionally offered by UK equity income shares. “With investment-grade credit you get good risk-adjusted returns, but if you compare them with equity dividends, you are not going to replace that lost income with yields from government bonds or high-quality credit,” warns Mr Dunbar.
If you want a similar level of yield to what UK equities used to offer you will need to take on the greater risk of investing in high-yield or emerging market bonds, both of which face challenges.
Rachel Winter, associate investment director at Killik & Co, adds that, although investment-grade bonds look attractive, this market became highly illiquid in the recent sell-off. And it had a notable and highly unusual effect on some large bond ETFs. Vanguard Total Bond Market Index Fund ETF's (BND:NMQ:USD) shares traded at a discount of around 6 per cent to the value of its underlying assets in mid-March. So Ms Winter argues that because trading can become difficult at times of market stress these types of bonds are not good investments to access via funds.
“We have seen cases [during the sell-off] where market makers will invent a price for a bond and we can’t get a bond at that price,” she says. “I don’t think bonds should be traded. I think you should buy them directly with a view to holding them until they mature to get rid of the liquidity risk. Bond fund managers could be forced to sell them when someone withdraws their money [from the fund]."
And higher-risk areas such as high-yield could be hit by defaults. US high-yield is particularly vulnerable because of its exposure to energy debt at a time of whipsawing oil prices. Emerging market debt, meanwhile, is risky even in calmer times and now could prove particularly volatile as developing economies struggle to handle the coronavirus outbreak.
“Latin America, Russia and places with poor infrastructure like India might be behind with [their response to] the virus," explains Ms Ibrahimpasic.
There also has not been the same level of central bank stimulus in emerging markets as in developed markets.
Some analysts, meanwhile, highlight the risk that the huge fiscal stimulus enacted around the world could, in the longer term, lead to inflation and interest rate rises. Bonds, in particular those with a longer maturity, can suffer major losses when rates rise.
And some argue that higher-yielding bonds are a bad deal for investors. “There’s a place for bonds in a portfolio but largely for government bonds,” says Glenn Meyer, head of managed funds at R.C. Brown Investment Management. “For yields you have to effectively take equity-like risks on the bonds but without the upside of equities.”
Fund selections
As fixed income faces so many challenges getting exposure to it via passive funds is probably not a good idea. Passive high-yield bond funds, for example, are highly exposed to the US energy industry. So if you want to invest in bonds you are probably better doing it via an active fund run by a prudent manager.
A good option could be a strategic bond fund that can invest in various types of debt and change its allocations to them when its manager thinks this is a good idea. It also means that these funds can offset riskier holdings with more defensive positions.
MI TwentyFour Dynamic Bond (GB00B57TXN82) is extremely flexible and well diversified, but its yield of 3.9 per cent at the end of March was lower than those of some of its sector peers. Its managers invest in niche areas of the debt market, as well as more mainstream bonds, resulting in a good spread of exposures in the fund. These include asset-backed securities, bank and insurance bonds, government debt, and US and European high-yield bonds (see below). MI TwentyFour Dynamic Bond may not escape a sell-off, but should be less volatile than dedicated high-yield or emerging market debt funds.
For investors comfortable with a greater level of risk, Royal London Sterling Extra Yield Bond (IE00BJBQC361) targets a very high level of income, most recently by focusing on BBB rated bonds – the lowest quality types of investment-grade bonds – and high-yield bonds. This is a higher-octane approach, which means that the fund offers an attractive yield, but may prove to be as volatile as some high-yield bond funds in difficult times. But as Royal London Sterling Extra Yield Bond is a strategic bond fund, its management team, led by Eric Holt, can both take advantage of opportunities in the market and move away from problem areas.
If you opt for a dedicated high-yield bond or emerging market debt fund, be very selective about the one you pick.
Royal London Short Duration Global High Yield Bond (IE00B9BQGL21) has some defensive characteristics. Its managers select holdings by assessing individual bonds and the macroeconomic situation, and seek to exploit inefficiencies in the high-yield market. As the fund’s name suggests, it has a lower duration – sensitivity to interest rate changes – making it a more defensive bet if central banks raise interest rates. The fund had around two-thirds of its assets in the US at the end of March, but it has a global remit so has flexibility in terms of which sectors and countries it invests in. The fund also had some exposure to government bonds, which could slightly offset any volatility. It had a yield of 4.3 per cent at the end of March.
M&G Emerging Markets Bond (GB00B4TL2D89) looks like a good way to get exposure to this asset because it can invest in both government and corporate debt, issued in both local currencies and hard currencies such as the US dollar. Its managers assess macroeconomic factors such as central bank policies and commodity prices to help them decide how much risk they are willing to take.
The fund had around two-thirds of assets in hard currency debt at the end of March. Some of the fund's largest allocations were to bonds issued by Mexico, Brazil, Russia and Singapore, which may be a reason why its performance has not been as good as that of some of its peers this year. However, it tends to perform well over the longer term and had an attractive yield of 5.6 per cent at the end of March.
