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What is a realistic portfolio income yield?

Bond yields have risen but inflation is making it harder to generate an attractive income
What is a realistic portfolio income yield?
  • Headline yields of UK equity indices are lower than they were
  • Holding a mixture of assets can help to generate an attractive yield
  • These should include some assets other than equities and bonds

At the current UK inflation rate of 9 per cent, you need to make an above long-term stock market average return on your money just to preserve the power of your savings. With best buy two-year fixed cash rates at around 2.8 per cent, and easy access accounts at around 1.5 per cent, the value of cash is being eroded.

But inflation is unlikely to stay at the current elevated levels for all that much longer, though energy prices are expected to rise in the autumn. This is because supply chain issues are likely to ease and the effect of higher interest rates should curb price rises. However, with the UK and world’s debt levels at very high levels, both at the corporate and national level, it is unlikely that interest rates will catch up with inflation in the medium term. As Charles Goodhart and Manoj Pradhan spelled out in their book, The Great Demographic Reversal, there are several reasons to believe that inflation could endure. Trade and access to a growing cheap workforce, particularly in China, has helped to keep prices down for decades and these are now going into reverse. The de-globalisation trend has been accelerated by the pandemic and Russia’s invasion of Ukraine, and the growth of the global workforce is slowing.  

This  means that the value of savings will continue be eroded. Yields generally are much lower now than they were a decade ago as a result of ultra-loose monetary policy initiated after the global financial crisis of 2008-9 and the coronavirus pandemic, but fixed income yields are now rising again. “Notably, nominal government bond yields have risen sharply so fixed income is starting to be more relevant again,” says Jason Hollands, managing director at Tilney Smith & Williamson. “Ten year gilt yields of 1.96 per cent are at the highest level in five years, and the direction of gilt yields are partly a driver for other income generating assets.”   

 

What level of income is realistic?

A key question now is what yield you can expect if you take a reasonable level of risk. On a recent Investors’ Chronicle podcast, financial historian Russell Napier noted that investors’ aversion to low yields has pushed them up the risk spectrum, both in fixed income and equities. And, in the words of Warren Buffett, “when the tide goes out, you see who is swimming naked”.

Investors also need to note that the headline yields on the FTSE All-Share index are significantly lower than they were a decade ago or even just before the pandemic as the shut down of the economy caused a permanent re-basing. The FTSE All Share's and the FTSE 100's yields were 3.2 per cent and 3.9 per cent, respectively, in late May, according to FactSet data. By contrast, at the end of 2019, the FTSE All-Share's and FTSE 100's yields were 4.09 per cent and 4.35 per cent, respectively.

Kamal Warraich, investment analyst at Canaccord Genuity Wealth Management, says that the general consensus today is that a yield meaningfully over 4 per cent is likely to be unsustainable in the long run. And to achieve a yield of 4 per cent portfolios have to be mainly allocated to risk assets. "The FTSE All-Share remains one of the highest yielding markets globally and is therefore a good barometer of the upper end of yields," says Warraich.

The MSCI World and MSCI USA indices' dividend yields' are 1.97 per cent and 1.5 per cent, respectively. But the recovery of global dividends post-pandemic has been encouraging – despite economic uncertainty and the impact of Russia's aggression in Ukraine. According to Janus Henderson, total global dividends rose 11 per cent in the normally quiet first three months of the year and the asset manager forecasts that payouts in 2022 will be 4.6 per cent higher than 2021. Almost 95 per cent of companies in Janus Henderson's Global Divided Index either increased or maintained their dividends in the first quarter of 2022.

Income focused funds have higher yields than broader benchmarks. For example, the average dividend yield of the Association of Investment Companies UK Equity Income investment trust sector is 3.87 per cent. Two large established trusts, Law Debenture Corporation (LWDB) and Murray Income Trust (MUT), which have healthy dividend reserves to help smooth payouts, yield 3.58 per cent and 3.91 per cent, respectively, and have outperformed the FTSE 100 in terms of share price and net asset value (NAV) total returns over the past five years. Law Debenture Corporation also owns a professional services business which has funded around a third of the trust’s income over the past decade and accounted for 18 per cent of the trust's net asset value (NAV) at the end of last year.   

To construct a balanced, medium risk portfolio, Warraich suggests holding between 30 and 35 per cent in fixed interest, 35 and 40 per cent in equities, and the remainder in alternatives. Hollands, however, suggests a higher equity allocation of 55 per cent in equities, 15 per cent in corporate bonds, 13 per cent in real assets such as real estate investment trusts (Reits), 10 per cent in government bonds, and the remaining 7 per cent in absolute return funds, gold and cash. 

Looking at the platform model income portfolios and multi-asset income, funds could be instructive too. VT AJ Bell Income Fund (GB00BH3W7552), for example, has 66 per cent of its assets in stocks, 29 per cent in bonds and the rest in cash. It has a 12-month yield of about 3 per cent. Between the start of this year and 27 May, the fund returned 0.76 per cent compared with -6 per cent for the Morningstar GBP Allocation 20-40% Equity sector. Hargreaves Lansdown’s equivalent medium-risk income portfolio has a very similar asset allocation, almost entirely made up of equities, bonds and cash.

A good way to get your bond exposure can be through strategic bond funds. Their managers' take a view on which parts of the bond market look like the best option in the current circumstances and avoid what look like problem areas. We include a number of these in the IC Top 50 Funds such as Jupiter Strategic Bond (GB00BN8T5596) which yields about 3.5 per cent. However, the fund made a total return of -5.5 per cent over the 12 months to the end of April, highlighting the risks associated with higher yielding bonds. 

 

Alternative assets for income

Reits and infrastructure trusts have particularly attractive characteristics for long-term income-seekers, although they have a number of risks. Peter Spiller, manager of Capital Gearing Trust (CGT) has grown his allocation to both sub sectors over the past year as returns on cash are non existent and equities look fragile. Capital Gearing Trust had 16 per cent in property and 8 per cent in infrastructure at the end of April. 

The attraction to these trusts is that they often generate income from very long-term contracts with inflation linkage built in. Among property Reits, there has been a bifurcation in the market with traditional high street shop owning trusts struggling, while warehouse Reits and other specialists such as healthcare Reits have been very popular and traded at premia to their NAVs. The average yield of generalist UK commercial property trusts is 4.64 per cent and they trade at an average discount to NAV of 5.71 per cent.   

Similar to Reits, infrastructure trusts have many different sub sectors. Mixed infrastructure trusts HICL Infrastructure (HICL) and International Public Partnerships (INPP) are among the oldest and largest, have well diversified income streams, and yield 4.7 per cent and 4.68 per cent respectively. They also tend to have longer contracts and higher inflation linkage than their renewable counterparts. However, both trusts were trading on premia to NAV as of late May, so could be vulnerable to a pull back if interest rates keep going up.

Many specialist infrastructure trusts have been popular too. Renewable trusts have benefited from increased power price expectations, which are used in the calculation of their NAVs. The average dividend yield of renewables energy infrastructure trusts is 5.3 per cent, but if you want to invest in this kind of trust look closely at its assets to ensure that you are comfortable with their quality as this is a more competitive area than it was previously and government contracts are less readily available. Spiller has also taken a stake in Cordiant Digital Infrastructure (CORD) and Digital 9 Infrastructure (DGI9) which listed last year and target attractive returns. However, these trusts are very concentrated with just a handful of assets which may increase the risks.   

 

Growth for income

Over the past decade, investors have increasingly focused on meeting income needs from the total return – capital and income – of a portfolio rather than natural yield alone.

“Focusing on total return rather than natural income has some benefits including more favourable tax treatment in the UK of capital gains versus income,” says Ed Park, chief investment officer at Brooks Macdonald.

For assets held outside individual savings accounts (Isas) and pensions, if you are a higher or additional rate taxpayer, you pay capital gains tax (CGT) at 20 per cent when you have used up your CGT allowance of £12,300 a year and any losses. The annual dividend allowance is £2,000, and higher rate taxpayers pay 33.75 per cent tax on dividends on top of this amount and additional rate taxpayers pay 39.35 per cent. 

However, for many people taking a total return approach and selling when you need income is an unwanted hassle. It is also not a good idea to take out money when the value of portfolios has fallen. 

While Hollands recommends focusing on taking a natural yield, he also suggests prioritising investments with income growth potential rather than very high current pay-out rates.

"It can be tempting to simply pick the highest yielding investment you can find, but if the value of your capital isn’t growing at least in line with inflation over the medium to longer term, the real value of your income distributions will dwindle over time," he says.