- 3 per cent looks like a sensible target for income investors
- Higher yields could compromise growth
The pandemic dealt a double blow to income investors with both swathes of companies cutting dividends and bond yields compressing. According to Link Group, dividends (excluding specials) paid to investors by UK-listed companies fell 44 per cent last year – the lowest level since 2011.
The good news is that dividends have been making a faster than expected recovery, with mining companies leading the charge and industrials and consumer discretionary also recovering strongly. In the second quarter of this year, UK dividends increased by over 50 per cent year on year, recovering to a level one-sixth below that of the second quarter of 2019. The dividend recovery has not been reflected by investment trusts, however, with Link reporting that UK equity income trust dividends were 9 per cent lower in the first half of 2021 than in the same period in 2020. But this discrepancy is due to a lag factor as it takes time for the cut in dividends received by the trusts to feed through to what they pay.
Although the outlook for income has improved, investors looking for a 4 to 5 per cent yield from a portfolio require a very different asset mix to the one required a decade ago, says CJ Cowan, portfolio manager at Quilter Investors and manager of its Monthly Income range of funds. You also need to take on more risk to get a 4 per cent yield.
Many investment professionals advocate investing for growth, and selling holdings as and when you need income. It is total returns that matter most to your wealth, after all. "You could argue now that targeting income in the current climate is probably more of an investment constraint than an investment style, as you are excluding lots of the very best opportunities simply because there is no dividend or income paid," says Richard Morley, senior investment manager at Brewin Dolphin.
But for some people this isn’t practical. Income portfolios at Canaccord Genuity, Charles Stanley and Quilter Investors suggest that a suitable target yield that should still protect your underlying portfolio is around 3 per cent. Brewin Dolphin's income portfolio, meanwhile, pays approximately 2 per cent income and Morley says " we feel that any attempts to significantly boost this yield will negatively impact the overall portfolio return".
Asset allocation
The key to building income resilience in your portfolio is diversification. As Cowan puts it: “The past 18 months have shown the importance of not overly relying on one particular region or asset class for income and instead spreading assets to get a range of sources.”
Quilter Investors Monthly Income Portfolio Fund (GB00BJMXGW38), which has a 12-month historic yield of 3.13 per cent, is currently overweight in equities compared with its benchmark as Cowan and his team expect the recovery to continue. But Cowan has been dialling back equity allocation in the US, European and global funds as “equities are around all-time highs and Covid risks remain”.
While UK equities were hit the hardest last year, Justin Oliver, deputy chief investment officer at Canaccord Genuity Wealth Management, says that the UK continues to look particularly attractive from a dividend perspective. Canaccord Genuity Wealth Management’s model income portfolio's yield is 3.05 per cent and it has significant exposure to UK equities.
The yield of the FTSE 100 index has dropped and, at time of writing, was 3.5 per cent compared with an average of 4.5 per cent in 2019, according to dividenddaata.co.uk. But the UK still has the highest yield of any major stock market and the opportunity for some companies to rebase their dividends should enable them to make future dividends more sustainable. As dividend cover, a measure of whether companies are making enough money to pay their dividends, in the UK market has been gradually coming down, the pandemic has given companies an excuse to make dividends more manageable.
Japan is another market with attractive dividend prospects. While MSCI Japan index's yield of 2.09 per cent is lower than that of the UK market, corporate prudence has resulted in well-capitalised companies. As we noted in June ('Look beyond the Olympics to long-term value in Japan', IC, 25 June 2021), Japanese dividends only fell 5.6 per cent last year and, on average, Japanese businesses are only paying out a third of profits as dividends. So there is significant room for payouts to grow over time.
Fixed income
Wealth managers still hold bond funds in their clients' portfolios to diversify them and provide some income. Cowan recently reduced Quilter Monthly Income’s investment-grade exposure after government bond yields moved lower in the second quarter, opting for strategic bond funds whose flexible mandates allow their managers to move up and down the credit spectrum as they see fit. Examples include Allianz Strategic Bond (GB00B06T9362) and Federated Hermes Unconstrained Credit (IE00BFB40P04).
Traditional investment-grade bonds are more skewed to macroeconomic risks than lower-grade forms of credit, which means that any rise or anticipated rise in interest rates can have a greater impact on their prices. Chris Ainscough, portfolio manager at Charles Stanley, likes bottom-up credit funds such as Schroder Strategic Credit (GB00B11DP098) which focuses on credit-specific risk rather than traditional investment-grade bonds. He says: “This fund will stay structurally light in duration and is reliant on the managers' skills in delivering alpha in credit selection.”
Alternatives
For inflation protection, core infrastructure funds HICL Infrastructure (HICL) and International Public Partnerships (INPP) have 0.8 per cent and 0.78 per cent inflation sensitivity, respectively, as we explained in 'The big rebuild' (IC, 20 August 2021). This is due to the majority of their revenues coming from government-backed inflation-linked contracts.
However, Ainscough suggests that listed equity infrastructure is the best income investment for inflation. Charles Stanley holds FTF ClearBridge Global Infrastructure Income (GB00BZ01WT03), which Ainscough says benefits from investing in companies that own hard assets where regulatory or contractual frameworks provide visibility over future cash flows. Roughly 90 per cent of this fund's holdings have a direct or indirect link to inflation.
Infrastructure trusts are a rapidly growing area with attractive income opportunities. But although there are several attractive options, make sure that you are aware of their risks. As Nick Greenwood, manager of Miton Global Opportunities (MIGO), pointed out in a recent Investors’ Chronicle podcast, a lot of money has flooded into renewable energy infrastructure trusts very quickly and left them with reasonably concentrated shareholder bases. Greenwood says that if the investment climate changes, there is a risk that these trusts could sell off.
Oliver says the latest change Canaccord Genuity has made to its income portfolios is adding Cordiant Digital Infrastructure (CORD) and Digital 9 Infrastructure (DGI9), taking advantage of recent share issuance by both companies. Participating in share issues can be an effective way to access infrastructure trusts at reduced premia to net asset values.
