Generating income from bonds and equities

In the years since the financial crisis struck, investors have flocked to fixed income in the search for yield.

The move was a result both of panic that the crisis could erupt again, with fixed income seen as a safer bet than equities, but it was also the result of savings accounts no longer offering inflation-beating rates.

The result has been to push the price of all fixed income to record highs and to push yields to record lows.

Gilts now yield barely 2 per cent and corporate bonds will likely only net you a yield of 4 per cent, so the temptation is there to search further afield for a decent yield.

This has made equity income far more attractive. The FTSE 100 is already yielding over 3 per cent and that includes all the lower-yielding companies, so a good equity income fund should be aiming for a yield of over 4 per cent.

While the yield is no more than you would get on corporate bonds, there is more chance for capital appreciation, especially as corporate bond prices are at record highs and could weaken.

But investing in equity income is not as simple as picking the best yielding stocks. As Glyn Owen, investment director at Momentum Global Investment Managers, explains: “Companies with the highest yields could be potentially dangerous. You could be drawn into buying value traps and broken business models.”

For multi-asset managers targeting an income return, then, the key is to assess where to invest across these staple sectors to build a strong balanced portfolio.

Equities: A global view

For Mr Owen, to avoid the pitfalls of equity income investing, you need to invest in quality companies, with high cashflow and low debt to total assets, which can predictably pay a sustainable dividend.

“Quality can transcend sector but you tend to find them in low cyclical and consumer staples, they tend to have a higher predictability of dividends,” he said.

Ian Rees co-manager on the multi-asset funds at Premier Asset Management, also tips stable large cap stocks as the key for an income portfolio, saying they can deliver a yield of over 4 per cent.

However, he says that “the issue is that they give you near term volatility. You need to be able to take a near term approach to equities in the face of that volatility.”

Mr Rees recommends that investors should look to diversify geographically where they get their equity income from. “There is a growing culture of equity income investing spreading globally due to the low return world we are in.”

Mr Rees says that the culture has spread through Europe and even into Japan and the US, and that investors should consider investing in global equity income, especially considering the concentration in the FTSE 100-focused equity income funds.

Most UK equity income funds will have a decent proportion of their portfolio in the biggest FTSE 100 companies because they are the dividend-paying staples. So the likes of pharmaceuticals like GlaxoSmithKline, tobacco companies like Imperial Tobacco and Vodafone will appear in most portfolios.