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Reduce your exposure to high-yield bonds

Our reader could improve his portfolio's diversification and cut its risk
March 15, 2018, Dennis Hall and Jason Hollands

Ian is 54 and has two sons but is no longer married. His home is mortgage-free and he has a flat that generates around £18,000 a year in rent. It is worth about £500,000 and has a repayment mortgage on it that has seven years left. 

Reader Portfolio
Ian 54
Description

Sipp, Isa, cash and property

Objectives

Build up funds to generate retirement income of £30,000 to £40,000 a year

Portfolio type
Managing pension drawdown

"I hope to keep working until I am 60," says Ian. "During this time I intend to reinvest all the dividends from my portfolio. I currently have around three to four years' living costs in cash outside the self-invested personal pension (Sipp) so I may continue to reinvest dividends in the first year or two after retirement, keeping the cash balance to assist when markets are troubled.   

"Once I start drawing from my investments I would like to take around £30,000 to £40,000 a year. I hope that the portfolio will keep pace with inflation, although I don't feel the need to match or beat any index. My aim is to generate a sustainable long-term income and some growth to meet my income requirements.

"I transferred my final salary pension scheme into a Sipp two years ago because the payments from the final salary scheme would have died with me. But this way the capital may remain largely intact and be available to my sons and partner.

"My final-salary pension scheme allowed me to access the transfer value from age 50 so I withdrew 25 per cent of this. I calculated that I need the balance to generate around 4 per cent a year to match the minimum payments I would have got from my final-salary scheme. I will not make any new payments into the Sipp, but will change its allocation.

"I expect to see the capital value of my portfolio fall around 50 per cent as markets take fright at some point. As I intend to leave the capital largely intact I hope not to be in a position where I need to sell investments at such a time, and hope that values eventually recover.

"Up until three months ago I used mainly to invest in FTSE 100 shares, but following the problems at Carillion (CLLN), Provident Financial (PFG) and BT (BT.A) I realised I was unlikely to be able to predict and avoid such issues. So I sold all of my direct share holdings, with the exception of one preference share, and am now building a portfolio of funds. Although the companies some of my passive funds track could have problems I have less exposure to them than if I held them directly.

"I aim to diversify my portfolio regionally and by asset class, so am investing it in five areas: tracker funds, fixed income, smaller companies and private equity, infrastructure, and other assets.

"I would rather be fully invested, but pretty much all of the funds I want to invest in are trading at 10-year highs so I am reluctant to put all my money into them just now. I am investing £10,000 a month, mainly into the tracker funds, which means I should have the money invested within three years. If markets fall during this time I will increase the monthly amounts I invest. 

"I intend to mostly invest in passive funds. But I think fixed income and smaller companies are areas where active managers can add value. 

"I have tried to limit overexposure to certain companies, although am aware that there is overlap between some of the funds. Howeve,r I am happy to be overweight UK shares via SPDR FTSE UK All Share UCITS ETF (FTAL) because of this index's historic yield."

 

Ian's investment portfolio

HoldingValue (£) % of the portfolio
SPDR FTSE UK All Share UCITS ETF (FTAL)46,0006.62
iShares Euro Dividend UCITS ETF (IDVY)36,0005.18
Vanguard FTSE All-World UCITS ETF (VWRL)53,0007.63
Henderson Diversified Income Trust (HDIV)16,5002.37
Invesco Perpetual Enhanced Income (IPE)28,0004.03
CQS New City High Yield Fund (NCYF)21,5003.09
RSA Insurance Group 7 3/8% CUM IRRD PRF #1 (RSAB) 20,0002.88
Volta Finance (VTA)20,0002.88
F&C Global Smaller Companies (FCS)21,0003.02
Henderson Smaller Companies Investment Trust (HSL)21,0003.02
European Assets Trust (EAT)20,0002.88
F&C Private Equity Trust (FPEO)6,9501.00
Harbourvest Global Private Equity (HVPE)1,0000.14
Renewables Infrastructure Group (TRIG)20,0002.88
HICL Infrastructure Company (HICL)13,7001.97
Bluefield Solar Income Fund (BSIF)10,2751.48
Henderson Far East Income (HFEL)20,0002.88
Murray International Trust (MYI)20,0002.88
Cash300,00043.17
Total694,925 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

There's a lot you are doing right. Your plans are based on a cautious assumption about future returns. You have tracker funds that don't have high management charges. And I like that you have exposure to private equity as I suspect a lot of long-run future growth might come from sources other than quoted stocks.

A high cash weighting is reasonable because there are good reasons to be cautious about future equity returns. These include the high ratio of world share prices to the global money stock, high levels of foreign purchases of US equities and tight discounts to net asset value (NAV) on many investment trusts.

I would, however, urge you not to try to time your buying too finely. Although the outlook for equities isn't wholly bright there is one strong reason for optimism – the dividend yield on the FTSE All-Share index is above its long-term average. This suggests that if you want to increase your equity exposure you should get on with it. It is impossible to time markets perfectly and if you are out of them you risk missing out on returns.

There are of course risks to being in markets and investments. One of these concerns your infrastructure holdings which incur political risk. Although a Labour government would be likely to increase infrastructure spending it wouldn't be so tolerant of the private sector making decent profits on government work. And that's a potential danger to infrastructure funds.

Four per cent is a fairly reasonable expectation for an average return from an equity-heavy portfolio. But there's variation around this average. 

We can, very roughly, quantify this. If we assume an annual standard deviation of returns of 15 percentage points, then even over five years there's around a one-in-four chance of losing money if you take an income of 4 per cent. And over 10 years there's around a one-in-six chance.

So could you cope with this? You have a flat that generates a nice income and gives you some protection, although its value would fall in a recession when share prices would also be hit. And you are, in effect, sharing risk with your sons who'll get a smaller bequest if shares fall, which helps spread the pain.

The cash outside the Sipp will help you through any market troubles. But those troubles might last longer, or occur later in your retirement, than you expect. So could you cope with this?

You must consider worst-case scenarios, not just average ones. For me, this would justify retaining a decent cash weighting. If markets rise over the next few years such a position would become more feasible because your larger portfolio would allow you to finance the same expenditure with a lower return.

 

Dennis Hall, chief executive officer of Yellowtail Financial Planning, says:

It was traditional when approaching retirement to gradually reduce equity exposure, shifting first into bonds and then into cash, creating a stable fund with which to buy an annuity. Nowadays you have the option of keeping your pension fund invested to provide income drawdown, which it will need to do for potentially 40 years or more. 

You plan to withdraw £30,000 to £40,000 from a fund that you hope will have a value of at least £800,000. This looks sustainable but will depend on things such as the equity allocation, how you deal with inflation and periods of poor performance.

To some extent, the larger the equity content the more sustainable the income withdrawal strategy. But to avoid selling equities during a market downturn you need to hold a proportion of an income drawdown fund in cash and bonds. My preference would be for government or very highly rated short-dated bonds that could withstand market shocks and sudden rises in interest rates. There is too much inherent risk in high-yield bond funds.

Having at least three years' income requirements in short-dated bonds would provide some protection against falling equity markets, although some people recommend holding as much as 10 years' income requirements in relatively secure assets. There are two current schools of thought about this.

One suggests that if you hold three years' income in bonds it should be periodically topped up from gains made by your equity holdings. The other is that you start with a bigger bond element which provides the income without any top-ups from the equity portfolio, but when the bond portfolio is exhausted you start drawing from a potentially much larger equity pot that has the capacity to absorb market falls.

Both strategies would work, but I'm uncomfortable with the bond/debt part of the portfolio for the reasons outlined above. However, as you are still several years from retirement you may wish to continue with this strategy for the time being.

 

HOW TO IMPROVE THE PORTFOLIO

Dennis Hall says:

I think your decision to divest from individual shares and use collectives is a sound idea, as this gives the portfolio greater diversification both in terms of asset type and individual securities, which is a really helpful attribute. 

I like tracker funds, and my favourite of your existing holdings is Vanguard FTSE All-World UCITS ETF (VWRL) because of its geographical spread and low costs. I'm also encouraged to see that there is no strong UK bias to the portfolio.

When looking at longer-term higher return factors, smaller companies tend to outperform larger ones, so it is good that you have a specific allocation to smaller companies. And value shares tend to outperform growth shares, which renowned US investor Warren Buffett has had success with.

With the portfolios I run, I look for low cost, low turnover funds that have a tilt to factor investing. These include funds run by Dimensional Fund Managers and the AlphaDex ETFs run by FirstTrust.

I also currently hold F&C Global Smaller Companies (FCS), Standard Life UK Smaller Companies Trust (SLS) and Marlborough Special Situations Fund (GB00B907GH23).

Private equity and infrastructure provide additional diversification, and I have held private equity via HgCapital Trust (HGT) in my own pension fund for the last 15 years.

But your general approach seems sensible and in terms of your portfolio holdings I'd only argue against the bond funds. 

 

Jason Hollands, managing director at Tilney Group, says:

You transferred away from the certainty of a final-salary pension into a Sipp, a risky and irreversible move that should only ever be undertaken after seeking professional advice and very careful consideration of the consequences. You did this so you could leave any residual assets in the Sipp to your sons after you die, which is very tax-efficient from an estate planning perspective. 

But heavy focus on a headline 4 per cent yield seems to be driving your investment selection too aggressively, and it has resulted in a portfolio with a rather uncomfortable asset mix. Most of the fixed-income exposure is to high-yield bonds and other debt instruments with low credit ratings. 

You do not expect to draw an income from your Sipp for at least a couple of years after you retire. So, given that you have at least eight years before you draw income from the Sipp, it seems too early to hold so many yield-focused investments.

Your allocation to equities looks broadly sensible for a medium risk portfolio, although your underlying exposure to Europe ex UK markets – if you also count the exposure from the global funds – is high.

You have only modest exposure to emerging markets, one of the few areas where valuations are currently trading below longer-term trends when measured on a cyclically adjusted price/earnings basis. So consider adding exposure to these via a fund such as Fidelity Emerging Markets (GB00B9SMK778) or Somerset Emerging Markets Dividend Growth (GB00B4Q07115). 

Reduce your weighting to high-yield debt, perhaps by moving some of this into more flexible funds such as MI TwentyFour Dynamic Bond (GB00B5VRV677). And consider improving the portfolio's diversification by adding some commercial property or real estate securities exposure.

You have £300,000 in cash and expect to see markets halve at some point, so some steady eddy targeted absolute return funds with low correlations to overall market movements could provide useful ballast in such tougher times. Up to 20 per cent of a medium risk portfolio could be invested in these, and options include JPM Global Macro Opportunities (GB00B4WKYF80) and Threadneedle Dynamic Real Return (GB00B93TQ868).

Your focus on trackers is not without risk as these will be fully exposed to any market downturns with no scope for defensive positioning. So consider supplementing these with proven active managers. Two active global funds to consider are Lindsell Train Global Equity (IE00BJSPMJ28) and FundSmith Equity (GB00B41YBW71).

The portfolio's exposure to infrastructure investment companies is quite high. The outlook for those exposed to UK projects has become increasingly clouded by Labour's pledge to "take back in-house" existing public/private sector contracts, if it wins the next election. And with the collapse of Carillion the political risks have increased. HICL Infrastructure Company (HICL) in particular has sizeable exposure to UK private finance initiative and public private partnership contracts, which is why its shares have moved to a discount to NAV. So I would be cautious about adding further exposure given the uncertain political climate.