Where to find income across the asset classes

In an era of high government debt, low inflation and sluggish global growth, investors are flocking into higher risk assets that pay an income, pushing up prices and causing yields to fall across the board.

Unfortunately, things seem unlikely to improve for some time. Cheaper oil and falling food prices have caused inflation to fall to new lows in recent months, all but dashing hopes that the official bank rate will go up before the year’s end.

The impact of low inflation, economic growth and interest rates, as well as quantitative easing, has been to push bond yields to ever lower levels. Interest rates paid on savings accounts have also all but dried up and annuity rates, which are tied to bond yields, have fallen to meagre levels.

Where can an investor find value in today’s markets? In an environment of sustained low inflation, investors will need to get used to achieving a lower level of income from all asset classes.

In the past, investors could rely on government bonds to provide a reasonable yield while also acting as a safe haven in times of uncertainty. But returns in this market are expected to be paltry for the next five to 10 years, a reflection that bond prices have climbed to historically high levels, leaving limited scope for further gains.

In fact, many short-dated European government bonds have negative yields to maturity, such as those in Denmark, France and Germany, helped along by quantitative easing by the European Central Bank.

We have even seen the yields on five-year German bunds turn negative, while longer-dated bonds are offering only marginally more attractive yields. Ten-year UK gilts are yielding just 1.8 per cent – hardly an attractive level to sustain a retirement income.

Nevertheless, on the positive side, UK gilts do at least offer a real return in excess of current inflation. And in any kind of global financial crisis, do not rule out their status as safe haven assets driving their prices higher and yields lower.

For investors willing to take on more risk, equity income stands as a viable alternative. At 3.3 per cent, the yield from the FTSE All-Share index appears more attractive than sovereign bonds from developed economies – low compared to the past, but there are opportunities for this yield to grow over time.

It should not be a surprise to see that the UK Equity Income sector was the best seller for the Investment Association last year.

One of the more attractive asset classes for income at this time is commercial property, which currently offers a yield of around 4-5 per cent. While 2014 was an exceptional year for commercial property investors with returns of around 19 per cent, it is safe to say that growth from here is likely to prove more challenging.

But this does not mean that we will see a sudden reversal of capital values. Crucial to this will be rental growth driving the market, which we are beginning to see emerge. We expect returns in the order of 10 per cent in 2015 and then 5-6 per cent per annum over the next five to 10 years, driven mainly by rental income.

As always, there are plenty of risks that could derail any one of these sources of income. We have already seen several major companies cut their dividends, and there is a chance this could become more widespread if the global recovery is not sustained and economic growth falters. As ever one’s strategy needs to be diversified across the asset classes to balance risk and return.

David Marchant is chief investment officer at Canada Life Investments

DIVIDEND PAYERS

David Marchant, chief investment officer at Canada Life Investments, says:

“The sticking point with equity income is that dividends can fall as well as rise. Even companies that on the surface appear to be solid bets for yield can suddenly cut their dividends.

“In January, Tesco announced it would not pay a dividend for 2014-15 after it uncovered a hole in its accounts, while more recently Centrica, the parent company of British Gas, cut its payout after low prices for oil and gas caused its revenue to drop dramatically.

“On the positive side, BP and Royal Dutch Shell – two solid dividend payers – have vowed to maintain their dividends and will instead cut costs elsewhere in light of lower oil revenues.”