Looking for income in alternative places

A decade of ultra-low interest rates has pushed bond yields off a cliff and resulted in a forced migration by income investors into more volatile equity funds. But while ‘the hunt for yield’ has become a real battlefield, there’s no shortage of attractive yield opportunities in less well patrolled parts of the market explains Helen Bradshaw.

If you’re serious about generating a consistent and sustainably high level of monthly income from a portfolio, you need to look a little further than the two former mainstays of the income investment world, namely the equity and bond markets.

While both still have an important part to play, with c$17trn of government bonds around the world now offering negative yields – and even Greece getting in on the act – it’s clear that the world has moved on over the last decade. 

Meanwhile, although equity dividend levels have held up well, they’re just as volatile as they ever were. Thanks to different accounting practices and special dividends there’s little rhyme or reason to when companies in the same index choose to pay their dividends. This means that the income profile from equities alone is just far too ‘lumpy’ if you’re committed to delivering a consistent monthly income to your investors.

The alternative approach

The solution lies in widening the net to embrace a far wider cast of characters, especially those currently labelled as ‘alternative’. As part of a multi-asset class portfolio, a significant weighting to alternatives offers two great boons. 

The first is the opportunity to invest across a far broader investment canvass by diversifying into areas that are less correlated to equity and bond markets. The second is the opportunity to create a far wider range of pay-out dates than the (generally) quarterly income distributions that derive from equity and bond funds. 

For portfolio managers with the scale and resources it requires to properly research and trade in alternative strategies, there are rich pickings to be had. 

Making it work

At first blush, few investors would expect private equity to fit snuggly in an income portfolio thanks to its reputation for volatility and low dividends. However, it’s a broad church and numerous managers in this space have set out their stalls to cater for income investors. 

This knowledge led us to both the Princess Private Equity Fund, which focuses on Europe, and the Neuberger Berman Private Equity Fund, specialising in US opportunities. The former offers a reliable yield of around 6% thanks to a mature portfolio of high-quality real assets that range from private schools to discount retailing parks. Its veteran managers take a conservative approach to protect the dividends they pay-out which means the fund offers us a great way to diversify our European equity exposure. 

It’s a similar story with the Neuberger Berman fund. Due to its preference for share buybacks, the dividends paid by the US stock market have never been heroic with the yield on the S&P 500 index generally floating below 2%. Neuberger’s fund offers a yield north of 4% and draws on a whole different set of growth drivers than the main market. 

The same investment rationale led us to smaller company strategies such as Montanaro’s UK Income fund which yields nearly 4% a year, and ‘smart beta’ approaches such as the SPDR UK and European Dividend Aristocrats funds.

Each of these funds offer us a means to diversify our regional exposure and the timing of the income payments we receive across the year, which is crucial to generating a ‘smoothed’ monthly income. 

Renewed interest

Another important part of our alternatives exposure comes from infrastructure and renewable energy assets; both pay attractive levels of yield, but such assets again come with their own set of care instructions. 

In the infrastructure space we own the International Public Partnerships Fund (INPP), a diverse global portfolio of high-quality infrastructure assets ranging from the £5bn Thames Tideway Scheme to military housing, schools and hospitals. INPP’s primary origination abilities set it apart from its peers and these have led to a number of attractive acquisitions which should facilitate its ability to continue delivering stable, predictable returns over the long term. Meanwhile, the cashflows generated by its holdings have the highest level of inflation linkage in the peer group, helping INPP to deliver steady dividend growth over time.

Like most infrastructure assets, its share price is vulnerable to changes in sentiment from political threats, most notably from the left. Consequently, Labour’s self-immolation in the December general election bodes well for valuations in the sector. 

We also own two attractive renewable energy-based strategies: Renewables Infrastructure Group (TRIG) and the Foresight Solar Fund. These offer yields of around 5% that are more than 50% underpinned by generous government subsidies. 

Borrowed wisdom

Elsewhere we have a number of ‘alternative fixed-income’ strategies which offer attractive yields alongside lower correlation to traditional fixed-income assets. Several of our holdings here specialise in loan assets and their floating-rate exposure helps insulate returns from interest-rate risk. 

As an asset class, loans offer an attractive risk/return profile especially when compared to high-yield debt given their senior ranking in the capital structure and interest-rate linkage. NB Global Floating Rate Income and CVC European Credit Opportunities are two examples here; both are managed by experienced, market-leading teams that maintain a quality focus. Both also offer yields in excess of 5%.  

In the same stable is the Biopharma Credit Fund, a unique strategy that focuses on capturing the royalty income streams from licenced pharmaceutical products and vaccines. It’s an interesting and fast-growing asset class, and, like its stablemates, it offers an attractive yield (c7%). 

Building positions

Like many of our holdings in more illiquid areas, such as infrastructure or private equity, these holdings are all closed-ended vehicles which, while adding an element of market risk, are in our opinion better suited to these areas given the stable asset base the vehicles provide.

The flip-side of the market risks they carry is that, for patient investors like us, they offer the opportunity to take advantage of any shifts in share price caused by sentiment or newsflow. In some cases, this allows us to buy in when newsflow has eroded a fund’s premium to net asset value (NAV) or even moved it to trade at a discount. 

Careful position building in such opportunities means that our portfolios can enjoy both the income such strategies generate and the price recovery that follows a period of volatility. 

Saddling rainbows

Embracing different investment structures, alternative income streams and a broad swathe of specialist investment strategies is all part of the mix. While every asset class under the hood has its own distinct characteristics and handling instructions, combining them in just the right proportions, at just the right times, can create that rarest of beasts: a portfolio that delivers a smooth, sustainable income to your clients every month of the year. 

For further information on the Quilter Investors Monthly Income range, please click here

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