The hunt for income has never been so challenging. Yields on traditional core bonds are at record lows, and leaving money in the bank is a losing proposition in the long run because of virtually zero returns on cash investments. Add inflation into the mix and real returns are negative on many investments.
In the current environment, an increasing number of investors have been turning to alternative sources of income. These sources can not only diversify investors’ portfolios better and lower their overall risk, but offer very low and even negative correlations to traditional asset classes.
These include non-traditional asset classes such as master limited partnerships (MLPs), preferred stock, real estate investment trusts (Reits) and emerging market debt, which seek to generate attractive levels of yield compared with low interest rates in many developed markets.
However, Michael Fredericks, head of US retail asset allocation for the BlackRock Multi-Asset Client Solutions (BMACS) Group, stresses that these asset classes require specific knowledge.
Patrick Connolly, head of media relations at AWD Chase de Vere, agrees. “As a starting point you need to understand exactly what you are trying to achieve, over how long and the risk you are willing to take. This will dictate how you structure your savings and investments,” he says.
Real estate investment trusts (Reits)
A Reit is a security that sells like a stock on the major exchanges and invests in property directly. After paying a fee to convert to Reit status, however, a Reit escapes corporation tax. It must also pay out 90 per cent of its property income to shareholders. Individuals can invest in Reits either by purchasing their shares directly on an open exchange or by investing in a mutual fund that specialises in listed real estate. Reits have an average yield of 3.24 per cent, according to Morningstar.
Mr Connolly says: “With little if any economic growth likely, property investments face challenging times ahead where any capital gains are likely to be muted, rental yields could fall and there is the risk of increases in vacancy rates.
“We expect the returns of 2011 to be repeated, with ‘bricks and mortar’ property funds producing small positive returns in the coming years. This is likely to come from rental income rather than capital gains,” he adds
Bank loans
Bank loans, which are typically high yield credit, have increased in popularity, as they can offer investors yields of approximately 5-6 per cent per year. The risks include absence of a broadly accessible active market, making loans difficult to dispose of.
However, Joe Lynch, portfolio manager on the Global Floating Rate Income fund at Neuberger Berman, claims that loans offer protection against potential losses.
“They’re non-investment grade, but we sit at the top of the capital structure, so we’re secured by all assets of a company,” he says.
“When we make these loans, we tell the company that they have to secure them with all of their assets. So loans for that reason are seen as defensive and offering good downside protection.”
He adds, however, that they suit sophisticated investors who understand the risks.
“The issuers are not investment grade so they don’t carry the same high-quality characteristics as government debt or investment-grade companies. They do carry more risk, so they suit people who are confident in adding more risk. To me it should be a complement to, or substitute for, high yield.”
Steve Casey, another portfolio manager on the fund, observes that last year only 0.2 per cent of the issuers of such instruments defaulted in the US, and he is hard pressed to see this going up above 2 per cent in the next few years.
“Corporate America is in good shape,” he says.
Of course, this isn’t the case worldwide. Martin Rotheram, who covers Europe and the UK for the fund, says that the European picture is less rosy.
“We are seeing select issuance in Europe. The number of deals that we’re seeing is far fewer than in the US. The US is a $500bn (£315bn) market, whereas Europe is $120bn, so about the third of the size.
“The ability - linking that in with the [difficult] macroeconomic picture - to find new issuance over here is probably a bit grey,” he adds.
Venture capital trusts (VCTs)
VCTs are often considered as tax planning vehicles where the benefit of initial income tax relief is usually highlighted. One of their major benefits is that dividends are tax free and the established generalist VCT managers have been paying consistent dividends to investors for many years.
Mr Connolly says: “Because investments are made into small companies the risks are high, which is why such attractive tax benefits are offered. However, those investing with an experienced manager can achieve a consistent tax-free income stream of between 5 and 8 per cent per annum.”
“We particularly like established VCT managers such as Baronsmead and Albion Ventures.”
Structured investments
In the past, many structured investments were designed to produce attractive levels of income, usually 7-10 per cent a year, with the return of capital depending on the performance of stockmarket indices. Recent advocates of using structured investments for income include Sisouphan Tran, head of structured investment house Harewood Solutions (see article on page 17).
However, Mr Connolly says that providers are starting to take more and more risks with the underlying capital to maintain a high level of income. When stockmarkets fell between 2000 and 2003, many of these products failed to deliver, and some investors lost a large proportion of their underlying capital.
“Since that time the number of income-producing structured products in the retail market has been very small,” he says.
Emerging market debt
Whereas debt in the developed world isn’t yielding much, emerging market credit funds have become more popular in recent years based on strong short-term performance figures and attractive yields of around 6 per cent per annum.
Emerging market governments and economies also appear to be in a stronger financial position than those in the western world, as they are generally less crippled by huge levels of debt. The likes of First State, F&C and Franklin Templeton have vehicles positioned in this area. While these types of funds can provide overall diversification in an investor’s portfolio, Mr Connolly stresses that the strong returns achieved in recent years should be seen as a warning sign rather than a buying opportunity.
“Investors too often jump into an investment after it has already performed well and often when it is nearing its peak. Emerging market debt funds are exposed to potential political risks, liquidity and corporate governance risks,” he says.
“From an individual investor’s perspective, the biggest risk is that emerging market debt will not provide the security of traditional fixed interest holdings. Therefore if investors hold a significant proportion of their fixed interest weighting in emerging market debt, this will increase the overall risk profile of their portfolios and make them more susceptible to overall capital losses, especially if stockmarkets fall,” he adds.
All investments have a risk attached, however. Mr Connolly recommends that the most cautious investors should remain in cash, focusing on achieving competitive rates of interest and paying as little tax as possible, while accepting that the value of their savings may continue to fall in real terms. However, other investors should look at alternatives to try and generate a higher level of return.
He points out, nevertheless, that no investor should put all of their eggs in one basket. “It makes sense to include a wide range of income-producing assets in their portfolios, starting with a foundation of cash, equities and fixed interest and then considering alternative holdings to sit alongside these,” Mr Connolly concludes.
Simona Stankovska is features writer at Investment Adviser
