Equity and bond income value on the wane

With pension changes scheduled in the UK for April 2015 likely to further boost this demand, a key question is where to source the extra yield from and whether the traditional asset classes or equities and bonds have had their day.

On the surface it seems a binary approach of either equities or bonds as a way to source income is no longer applicable, with many turning to multi-asset or multi-manager strategies as a way to diversify both their risk and the income opportunities.

As Rob Burdett, co-head of multi-manager at F&C Investments, points out: “The go-to income sectors no longer offer the yield they once did, and investors need to look further afield, letting go of the bias towards the traditional sectors.

“Since 2010, the change in yield of the IMA UK Equity Income sector is negative 8 per cent and the IMA Sterling Corporate Bond sector is not fairing any better, down by 22 per cent.”

But is this really the end of equities and bonds as an income source?

Ascending the risk curve

Sheldon MacDonald, senior investment manager at Architas, explains the theme for 2014 has been “lower for longer, in terms of both interest rates and inflation”. He notes that as the economic picture has become more challenging and Europe edged towards deflation there has been renewed support for fixed income assets in the second half of the year.

However, he adds: “Artificially low interest rates – financial repression - means savers and investors have been pushed further along the risk curve in the search for yield, into high yield debt and equity income.

“When investors began to perceive a return to a more normal rates environment in 2013 and early 2014 this trade unravelled to some extent, but the return of ‘lower for longer’ sentiment has again created an upswell in demand for these asset classes.

“Within fixed income the least risky assets, government bonds, yield less than the more risky corporate debt sectors. Investment grade corporate bonds offer slightly higher yields than sovereign debt but credit spreads are low by historical standards and don’t offer much scope for further tightening.

“For investors to earn decent returns from the highest grade corporate bonds would require a fall in benchmark government bond yields, but if this is your view then investing in longer-duration sovereign debt would capture this gain far more efficiently than corporate debt which by its nature is shorter-term – and thus less sensitive to interest rate moves.”

Fixed income

Christine Johnson, head of fixed income at Old Mutual Global Investors, highlights the positives of the bond sector, even in the current challenging environment.

“One of the more attractive but frequently overlooked aspects of bonds is the predictable and inviolable nature of their cashflows. Unlike dividends - cashflows are non-discretionary. Everything, dividends, capital spending, pay rises, expansion, is second in line to paying coupons on debt.

“When things go wrong businesses from BP to Tesco cut their dividends as the first line of defence – they simply don’t have the choice on their bonds.”

At a time when companies such as supermarkets are under increasing pressure, with Tesco announcing it was cutting its interim dividend by 75 per cent earlier this year, this predictability is an advantage.

“You know what you are getting and when you are getting it - so you can calculate down to the last penny what you can pay out at any point in time. It allows structures like a predictable monthly payment from a fund,” adds Ms Johnson.

Of course with 10-year government bond yields at record lows, the area of fixed income investors are targeting becomes more important.

Mr MacDonald notes: “The corporate environment appears pretty benign at present: company balance sheets are in good shape, earnings are growing and cash flows are solid. There is therefore an argument for riskier corporate bonds.

“High yield is the next stop on the risk curve and although spreads have tightened here too, there are still pockets of value to be found where investors are adequately compensated for the added risk. There is much more idiosyncratic risk in this space, though, so careful scrutiny of the individual underlying investments is paramount.

“The key question is whether you are being rewarded for the extra risk you’re taking as you seek out extra yield. Factors like the region or sector can be important, while specific company fundamentals definitely are, even if the default environment is expected to remain friendly. Investors should be satisfied that the manager they pick can make these judgement calls consistently,” he explains.

Equity income

Elsewhere with equity markets moving higher towards the end of the year, there is still some scope for equity income returns, providing you look further afield than the traditional UK dividend payers. The latest UK Dividend Monitor from Capita Asset Services notes the top 15 dividend paying companies in the UK account for approximately 63 per cent of the total dividends paid.

Colin Morton, vice president and portfolio manager on the UK Equity team at Franklin Templeton, says: “Over the past year we’ve witnessed significant volatility in the equity markets, both in the UK and further afield, which – combined with the low interest rate environment – has created somewhat unchartered territory for a number of investors.

“Still, in spite of this backdrop, the importance of equities for income has remained, and seeking quality, cash generative companies that continue to increase their dividends year-on-year remains the fundamental bedrock of equity income investing.

“What has become apparent, however, is that investors’ expectations with regards to equity returns need to be recalibrated. With the current low interest rate environment dragging back the level of risk-free return, investors ought to be satisfied with 5-7 per cent returns.”

Mr MacDonald adds: “Dividend levels in many parts of the world are above the yields paid by investment grade bonds, and are even higher than some high yield debt. This, along with the potential for capital growth they offer, makes them relatively attractive. Of course, investors need to weigh up the likelihood that this potential will be realised.”

Nyree Stewart is features editor at Investment Adviser

nyree.stewart@ft.com