How to be an income investor in a world of higher yields

'Normal' is a subjective term, and one that's rarely been used when discussing markets over the past 15 years. But it's a word that more experienced investors are increasingly reaching for when it comes to one particular investment. Interest rates rising to levels more in line with historic trends has plenty of consequences for investors, from currency fluctuations to the differing effect rates have on different equity market sectors. But the most obvious impact is on a once sleepy asset class.

Bonds, which in the era of low rates and quantitative easing looked expensive and offered very little in the way of yield, have seen a huge reversal in the face of inflation and rising rates. The yields on government bonds, which move inversely to their prices, have spiked in the last year. A 10-year UK gilt now comes with a 4.4 per cent yield – not bad compensation to hold an asset that, despite recent volatility, still tends to be viewed as a risk-free investment. Higher rates mean that even cash can now offer a return, with money market funds and bank saving accounts offering attractive rates.

Recent investor behaviour reflects this: individuals have bought gilts directly, and also cut back on equity portfolios in order to buy bond funds. Investment Association data shows UK retail investors put nearly £5bn into bond funds on a net basis in the first half of 2023, a big contrast to the more than £2bn flowing out of equity funds in the same period. The European exchange traded funds ETF market has seen similar trends, with bond vehicles taking in a record amount in the second quarter of this year.

These decisions have implications for investors of all kinds. Bonds, which seek to offer more shelter for nervous investors seeking safer havens, are now finally paying a return again. But the shifts arguably pose the biggest questions for the humble income portfolio. With yield easier to come by in a relatively riskless way, how should an income portfolio now look?

Equities have long been the mainstay of income portfolios, given they can offer high yields and dividends that tend to grow over time, as well as the prospect of capital growth. Meanwhile, higher-quality bonds have served as more of a buffer, while alternative assets such as infrastructure have worked as another source of yield over the past decade.

Fast forward to the huge repricing of the bond market and that mix is in flux. For one thing, the traditional 60/40 portfolio of equities and bonds, for an investor who wants some growth (or income) with a degree of protection against stock market falls, now looks much more viable again.

The death and resurrection of 60/40 has been much discussed over the past few years, but some believe the sheer size of yield available on bonds means global investors should go even further in recalibrating income portfolios. “I would now have 60 per cent in fixed income and 40 in equities,” notes Tom Becket, chief investment officer at Canaccord Genuity Wealth Management. “Bond yields have now corrected and are higher than equity yields," he says. "If you look at income opportunities in the US they are limited. They are better in regions such as Asia, but that can come with higher risks.”

For income investors who rely mainly on UK assets, the equation is arguably slightly different, given domestic equities (and investment trusts) are in fact no laggard when it comes to yields, and some of the opportunities on offer are still highly enticing. 

Becket, in his words, is not taking a bearish view on equity markets here. Instead, he feels that bonds can finally generate some easy income (and total returns), giving the equities in a portfolio the breathing room to generate rich dividends and gains over a longer period, possibly with greater volatility on the way.

“Fixed interest is not there to be wildly exciting, it’s the engine room of your portfolio,” he says. “If it can [return] 5 or 6 per cent, the rest of the portfolio can do what it wants to do. With equities, a long run return of 6 or 7 per cent per annum is easier when bonds are giving you much more.”

Becket strikes more of a pro-bond stance than many market participants, but a glance at the starting yields on offer backs him up. As noted, a UK 10-year gilt now yields 4.4 per cent, a payment that is guaranteed provided the UK government doesn’t default on its debts. Similarly, investors directly buying government bonds with short maturities can lock in the return while limiting risk by simply holding them to maturity. Bond funds will give a form of exposure that is likely more diversified, less complex, but potentially with lower yields and returns. A crucial disadvantage, however, is that they do not provide the prospect of growing capital in the way that equities do.

'Natural' income

Some other considerations are also worth taking into account by the income investor. Higher yields mean that generating a decent level of natural income from a portfolio – the amount that can be produced by dividends and interest payments without needing to sell anything – is now much easier. Becket makes the case that generating 4 per cent a year without touching capital is feasible.

This perhaps puts a different slant on one long-running argument among investors. Hedge fund grandees have criticised UK companies in recent years for their obsession with dividend payments over capital growth, while star fund manager Terry Smith is known for his view that investing for total return makes more sense than just relying on dividend-paying shares. As he wrote in the Financial Times in 2018: “A portion of the returns that companies generate are retained and automatically reinvested on your behalf. This creates more value than you can ever capture by reinvesting dividends – except, of course, when the reinvestment is done badly with management investing when returns are inadequate.”

Just as companies focusing solely on dividends can be an issue, focusing too much on natural income in a portfolio can create similar problems. That’s because the desire for yield can lead investors into less attractive regions and sectors – high-yielding energy stocks, for example – at the expense of markets, most notably the US, that have powered so much portfolio growth in recent years.

But there are counterpoints: some investors like the reliability of dividends, and the alternative – investing for total return and banking capital gains once a quarter – can potentially introduce an element of market timing, as well as a greater degree of complexity when it comes to managing income streams. As a compromise, income investors could seek to have some growth assets mixed in with income-producing holdings, if only to ensure they're sufficiently diversified when it comes to market, geography and investment style.

A yield bonanza

Those pushing into fixed income should be careful about how they recalibrate their portfolio for other reasons. New money might be easy to deploy into bonds, but funds in the alternatives space have suffered some savage falls in the last year. Selling out of the latter to take advantage of fixed income 'bargains' could likely mean realising a loss.

Risk-averse investors are not unreasonably tempted by the easy win of holding government bonds, but it’s worth noting that ample opportunities can still be found in the equity space. Although the FTSE 100 has gone sideways after a brief flirtation with the 8,000 mark earlier this year, it offers a juicy forecast yield of 4.1 per cent for 2023 and 4.4 per cent for 2024 as of mid-July, according to AJ Bell figures.

That yield is easily attainable via the likes of a FTSE 100 ETF, while stockpickers can find plenty of UK shares (and investment trusts) that offer an income to rival what’s available in the bond market. At the time of writing in early August, there were plenty of shares with yields that look attractive but not worryingly high, including Tesco (TSCO) and Severn Trent (SVT) on 4.3 per cent, BP (BP.) on 4.4 per cent, Hargreaves Lansdown (HL.) on 5 per cent and Persimmon (PSN) on 5.3 per cent. Investment trusts offer a similar range, from UK income stalwart City of London (CTY) on 5.1 per cent to global equity income portfolio Murray International (MYI) on 4 per cent, Utilico Emerging Markets (UEM) on 3.7 per cent and CT Property (CTPT) on 4.8 per cent.

The stocks and trusts listed above are clearly not without their challenges, and some of the companies that have yields in excess of the 7 or 8 per cent mark are riskier still – share price falls having pushed up said yields. But investors need not reach far for reassurance on this front.

For one, dividends across the market look well financed, with dividend cover estimated to come to 2.2 times in 2023 – above the 'two times' level that investors sometimes use to gauge particularly safe payouts. That, in theory, means payouts will tend to hold up even if the market hits a bump in the road.

As the AJ Bell report notes: “An economic downturn remains a major danger, but perhaps investors can draw some comfort from how dividend cover is much better than it was ahead of the mid-cycle growth bump of 2015-16 that took such a toll on aggregate FTSE 100 payments. As a result, their shareholder distributions may not quite be the same hostage to fortune that they proved to be in 2016 or 2020, should another unexpected shock emerge.” 

Secondly, both equities and alternative assets still appeal over bonds over the longer term because they can fight inflation. Companies and investment trusts remain highly motivated to increase their dividends over time, ideally with a degree of inflation linkage, meaning that payouts can help hold off the effects of inflation over the longer run – even if any recent increases lag the current high levels of rising costs.

In the investment trust space that remains especially relevant for income stalwarts such as infrastructure funds. As Peel Hunt analysts noted last month: "Greencoat UK Wind (UKW), NextEnergy Solar (NESF) and Octopus Renewables Infrastructure (ORIT) each stand out for their double-digit target dividend increases of 13.5 per cent, 11 per cent and 10.5 per cent, respectively, in line with inflation to the end of December 2022.

"Conversely, of the established infrastructure companies HICL Infrastructure (HICL) is notable for having guided to no dividend increases through to financial year 2025. This stands in contrast to closest peers BBGI Global Infrastructure (BBGI) and International Public Partnerships (INPP), who have guided to roughly 6 and 2.5 per cent dividend growth, respectively, for the next two financial years. Across the infrastructure and renewables strategies which are not still in post-IPO ramp up, the median target increase for the next full year is 4.8 per cent."

Alternative assets like these sold off fiercely last year, in part as a response to rising bond yields and interest rates that obliged them to increase the discount rates used to value their portfolios, but it's worth noting that they now share a similar recovery narrative to fixed income. The likes of infrastructure and property funds also proved vulnerable in the last year partly because they have high levels of debt, leaving them exposed to a higher cost of borrowing. But if bond yields start to fall again, these pressures will lessen.

As such, some bargains stand out in the alternatives space for those who want even higher yields. Rachel Winter, partner at Killik & Co, points to Cordiant Digital Infrastructure (CORD), a fund which recently came with a share price dividend yield of 5 per cent and a share price discount to net asset value (NAV) of close to 30 per cent. Cordiant and its rival Digital 9 Infrastructure (DGI9) may have held up less well than some peers because their sub-sector is still relatively new to investors, while both have run into certain idiosyncratic problems. The Cordiant fund, for example, took longer than hoped to get a chunk of its IPO proceeds deployed via an investment that waited some time for regulatory approval.

Sticking with the investment trust space, Becket also points to the alternative assets that “have paid the price of rising bond yields and interest rates” as one place to look, including the likes of infrastructure. “My suggestion would be those are good to look at, especially those with attractive yields, in the coming year,” he says. It’s worth noting that alternative trusts are a fairly esoteric bunch, taking in the likes of music royalty funds and ship leasing vehicles. Other asset classes are easier to comprehend. Winter points to LondonMetric Property (LMP); as that implies, property trusts also come with some chunky yields. Most UK commercial property trusts currently come with a share price dividend yield of more than 6 per cent, although plenty of uncertainty comes with that bargain price tag given the current outlook for residential and commercial real estate.

Higher yields might be easier to find but, as per usual, this can be as much of a red flag as a welcome sign. But higher bond yields do mean investors can – and should – be more discerning.

“An old rule of thumb [was] that any equity dividend yield that exceeds the 10-year gilt yield (in effect the risk-free rate) is probably too good to be true,” AJ Bell notes. “A decade and more of zero interest rate policies from the Bank of England wrecked that, but now policy is returning to something like normality it will be interesting to see if this old rule reclaims its former authority.”

Even with markets recovering, the 2022 sell-off has left many dividend yields at levels twice as high as the benchmark set by 10-year gilts, some of which may look too good to be true. But the new normal should at the very least mean more choice for the income investor.