Fixed Income  

Don’t put all your eggs in one basket

This article is part of
Hunt for Income - March 2015

With interest rates at an all-time low, it is no surprise that investors are turning to portfolios focused on the delivery of income.

An ever-ageing UK population and the distant prospect of banks paying an above-average interest rate on deposit savings mean demand is set to continue for the foreseeable future. Meanwhile, with the recent increase to Isa allowances and greater flexibility planned for the UK pension market, investing for income looks set to become even more important.

So, what are investors looking for from the industry’s income-focused portfolios, and how can the portfolios stand out in today’s crowded market? The answer is never simple but, with growing global risks, investors are increasingly looking for significant payouts, particularly from UK companies (circa £80bn), and therefore portfolios with increased exposure to the most established household brands.

Since the market sell-offs in 2008, demand for less volatile assets has increased as risk-averse investors have been forced into riskier assets to replace the yields they can no longer get from deposit funds and government gilts. This trend has continued as concerns over Europe, Russia and China have emerged.

Portfolios that focus on income tend to provide a regular stream of cash payouts that protect investors in times of market downturns. However, in rising markets there is the potential for subdued gains as companies pay out parts of their profits rather than reinvesting for future growth, as we have seen across the UK’s largest housebuilding stocks. For now, investors should choose a portfolio that can deliver a combination of both capital returns and income and over time – income-yielding portfolios will prove rewarding without necessarily sacrificing the investor’s capital.

But which assets can meet investor demand for income at a time when traditional income assets, bank deposits and gilts continue to provide minimal return opportunities? There are three main asset classes to consider: equities, property and bonds. These can still offer yields of between 3 per cent and 5 per cent, compared to a 10-year gilt yielding 1.35 per cent at the end of January – an all-time low. With such low yields, investors are at risk of significant capital losses. Bonds, through their duration levels, have varying degrees of price sensitivity to changes in interest rates. Currently the Gilt index has around eight years’ duration, which implies with every 1 per cent rise in yields there will be an 8 per cent fall in capital values.

Yields on the FTSE 100 have been in the region of 3.5 per cent, which in itself offers investors a return over and above current UK CPI levels. It is worth remembering also that equities provide an opportunity for investors to share in the future growth of the company, which is supportive to protecting the real value of capital over the long term.

However, the level of risk associated with investing in equities is not for everyone and therefore company bonds should be considered, as these provide greater certainty for investors through set redemption dates and known repayment amounts. Some portfolios can even invest in gilt futures, which offer further protection against rate rises for bond investors.