Equities beat bonds but is window of opportunity closing?

But the recent raging bull market in fixed income has changed all that.

Investors seeking sanctuaries to park their money have piled into government bonds, sending yields to record lows. 

At the same time equities have also rallied, but not to the same degree as the bond market. As a result, the FTSE All-Share index now yields more than 10-year gilts.

It is small wonder then that UK equity income funds have been bestsellers and steady performers in recent years, yielding 3-5 per cent a year.

But that may be about to change. In January, for instance, net sales of UK equity income funds in Isas – a proxy for retail investors – were a negative £41m. 

One reason may be the prospect of returning inflation. That’s not just a threat to holders of fixed income assets: equity income investors should be concerned, too.

Rising input costs as a result of sterling’s post-Brexit devaluation is putting pressure on companies’ profit margins, and therefore their ability to pay dividends.

For example, sectors such as retail are also trying to absorb other cost pressures, such as the national living wage, the apprenticeship levy and the introduction of auto-enrolment.

Then there’s the currency issue. When Theresa May announced on April 18 her plans for a snap general election, the pound rose sharply but the FTSE 100 index fell, recording its worst day since the immediate aftermath of the EU referendum. 

The reason for this drop is that the blue-chip index is weighted towards businesses that earn a large amount of their revenue in dollars. 

But the fact that FTSE 100 heavyweights, such as oil majors and pharmaceuticals, earn much of their income overseas also means they are less dependent on the performance of the UK economy for their profits, and therefore their dividends.

In the long term that means they remain a good bet for investors seeking relatively low-risk equity income. Similarly, domestic utilities tend to provide stable and attractive dividend streams for income-hungry investors. 

Even banks like Lloyds Banking Group – still recovering after the financial crisis – are returning to the dividend list. If their revival continues, the banks may at some stage be able to resume paying the kind of chunky dividends they were once famous for.

Nevertheless, it looks as though the window of opportunity for equity income investors may be about to close, at least in the UK. As a result, investors are looking further afield in their remorseless hunt for yield. 

Indeed, we are seeing more and more income funds with global mandates looking to diversify their holdings by geography as well as sector, especially in cash-rich Asia. 

Such diversification should be music to the ears of the more risk-averse income investor, even if that also means more exposure to relatively new – and under-researched – asset classes.

Such an approach also means greater exposure to geopolitical risk: whether it be Brexit, North Korea, or the fluctuating state of US relations with China. 

But even the most domestically minded equity income investors know we live in an interconnected world. For them, the advice remains the same: spread your risk and think long term.

In the meantime, expect the yield gap between equities and bonds to narrow, though it is unlikely to close altogether. 

A reversion to the historical mean still looks a long way off.

Robert Vaudry is managing director of investments at Wesleyan

Top-five UK dividend-paying firms, 2013-17

Source: Capita UK Dividend Monitor: Issue 29, April 2017