Generating income from bonds and equities

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.

This concentration hit a lot of equity income funds in 2010 when BP, one of the biggest dividend payers, suddenly cut its dividend following the oil spill in the Gulf of Mexico.

This has led many other income managers to diversify overseas, and not just in developed markets.

James Burns, head of the multi-manager team at Smith & Williamson, says that emerging markets are starting to look more and more attractive for income as the payout ratios of companies in emerging markets improve.

This view is shared by Olivia Mayell, portfolio manager for the JPM Multi-Asset Income fund.

She explains: “With emerging market income, people have not considered the dividends but managers can find good companies paying a good income there, and that’s a relatively new story.”

But diversifying by region is not the only option open to equity income investors. Increasingly, managers are looking to diversify by market cap.

F&C multi-manager Rob Burdett says that investors need to look beyond the big, lumbering equity income giants for funds that are smaller and more nimble and can take advantage of the abundant income opportunities in the small and mid cap space.

Mr Burdett recommends the PFS Chelverton UK Equity Income, but equally good performers in this space include the CF Miton UK Multi Cap Income fund, run by Gervais Williams, and the Unicorn UK Income fund, run by John McClure.

These funds all pay out a yield often bigger than the larger equity income funds and, while they will likely be more volatile, offer good diversification for investors.

Fixed income: High-yield opportunities

Yet for those not able to stomach the volatility from equities, there are still opportunities in fixed income, just not what - or where - they once were.

Ms Mayell says that it is a struggle to find value because “you are not being paid for the risk and the yield is not good enough”, which is a view shared by managers when the yields on corporate bonds are dipping below four percent.

Ms Mayell is much more optimistic about the high yield story. She says: “The high yield assessment is more straightforward. You can get a meaningful yield, they have good fundamentals with a low default rate and it is a stable market, particularly in the US as it is better for liquidity.

She acknowledges that “yields have come in a bit and and spreads have tightened up” and that tightening, bringing yields on high yield down to record lows under 6 per cent, is worrying some managers.

JPM Multi-Asset Income fund has started to take some profit from high yield bonds, not because of anything wrong with the asset class but, but because the managers are seeing more opportunities in equity income and are worried about the money pouring into high yield.

Ms Mayell says: “It has become a busy trade and a lot of people have gone in and you do not want a lot of concentration in your portfolio.”

Those looking at diversifying their fixed income portfolio might also want to consider emerging market debt as it can offer a good yield, but that has also dropped as money has poured into the asset class.

But that is the case with income everywhere, from government bonds to quality equity income, all areas perceived to be paying a good income are being snapped up and becoming expensive.

The consensus among multi-asset managers is that equity income holds the most opportunities, thanks to their ability to grow their dividends over time and, if the market recovery continues, the better total return should make up for the income being only around 4 per cent.