What are the long-term trends for equity income vs fixed income strategies?

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Rathbones
What are the long-term trends for equity income vs fixed income strategies?

Ask an investor which one out of equity income and fixed income could be relied upon the most to meet their income needs and many people would probably choose equity income.

There are some key differences between the way the two asset classes pay an income, which are worth advisers and especially clients understanding before they invest.

Matthew Yeates, investment manager at Seven Investment Management, says: “Income from equities comes from the share of profits paid out through dividends, after paying debt, versus the income from fixed income instruments from debt paid out before profits. 

“All other things equal, over the long term, this should make income from debt less risky than that from equity as it is not contingent on companies making a profit.”

He warns though that the demand for income producing stocks though has made them expensive on many metrics. 

“Although, traditionally, income-paying stocks have been associated with being value stocks, this is less obviously the case at present, with many bond proxies trading very expensively on traditional multiples.” 

In the UK we are lucky – we have a long-established culture of paying dividends so UK equity income managers have a wide choice and can pick and choose.Darius McDermott

Nevertheless, UK equity income funds frequently top best-selling fund lists.

Equity income has become more popular than fixed income strategies in recent years as long-term real interest rates have fallen, points out Peter Elston, chief investment officer at Seneca Investment Managers.

He says: “25 years ago the real long-term gilt yield was 5 per cent, whereas today it is -1.5 per cent. 

“We are finding good income opportunities in the mid-cap space in the UK, where there tends to be a growth kicker too.”

Dividend culture

It is also, in no small part, down to the UK’s strong dividend-paying culture.

Darius McDermott, managing director at FundCalibre, observes: “The current trend (one that has been in place for some years now) is that the yield on equities is higher than the yield on bonds. 

“It has made equity income funds very attractive. The yield on the FTSE All Share [index] is about 3-4 per cent, for example.”

He notes: “In the UK we are lucky – we have a long-established culture of paying dividends so UK equity income managers have a wide choice and can pick and choose. There are a large number of companies paying a decent yield.”

But the dividend culture is improving in other regions now, giving investors more reason to diversify their income stream by investing in global equity income funds over regional equity income funds, Mr McDermott confirms.

This is backed up by net retail sales figures from the Investment Association (IA) which show the IA Global Equity Income sector has seen positive net retail sales in eight out of the past 13 months, peaking at £122m in June 2017.

Over the same period, the IA UK Equity Income sector registered net outflows in 11 months.

Net retail sales of the IA Global Equity Income and IA UK Equity Income sectors from Jan 2017 to Jan 2018

 Jan-17 Feb-17 Mar-17Apr-17 May-17Jun-17Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18
IA Global Equity Income sector 3253-344368122-393468-94430-23
IA UK Equity Income sector-76-18323973-23-428-79-165-9-272-119-87-339

Source: Investment Association

“Around the globe, dividends are becoming more established and important, and 2017 was a bumper year with 11 out of 41 countries making record payments, according to the latest Janus Henderson Global Dividend Index,” he adds.

Andrew Morgan, portfolio manager of Alpha:r2 at Walker Crips, flags the issue of concentration risk in equity income portfolios.

“For equity managers, a successful dividend strategy demands that companies they invest in not only have high dividend yields, but yields that are sustainably growing, together with good interest cover and cash flow,” he explains. 

“This inevitably results in a concentration in certain sectors, such as utilities, pharmaceuticals, tobacco and oil majors.” 

Far and wide

This also accounts for the growing interest in global equity income portfolios, however.

Mr Morgan suggests: “One obvious result of this concentration, in what are otherwise generally pretty conservative companies, is that there is also a concentration in regulatory and political risk: each of those key sectors has an above-average exposure to regulatory change. 

“One way of mitigating this concentration of risks has been to diversify geographically. A big trend in the past 10 to 15 years has been the growth of global equity income as a sector, which allows the opportunity set to widen dramatically, while reducing risk but maintaining the higher income levels.”

Fixed income managers, by contrast, have a broad array of sectors from which to choose, he adds, noting “although inevitably those more stable sectors, like utilities, are the ones which allow the greatest levels of indebtedness”.

He has seen a couple of significant trends in fixed income strategies over the past 10 years or so.

Mr Morgan highlights: “A clear trend over the last decade has been the spurning of gilts, as quantitative easing has pushed their yields ever downwards, well below the rate of inflation.

Over the past few decades it has been relatively easy to generate an income and capital gain in fixed income because sovereign bond yields have been falling consistently, whereas equity strategies have been relatively volatile.Anthony Rayner

“For private client managers, another change over the past 10 to 15 years has been an increased availability of bonds for smaller investors.” 

He explains that rather than having minimum investment sizes of £100,000, a variety of bonds are readily available with minimum investment amounts as low as £1,000. 

“This allows clients to take advantage of fixed income investments, with their security of income and ability to balance a portfolio at a time of equity turbulence, while simultaneously bringing down the overall total expense ratio of the portfolio.”

What will the next 10 to 15 years bring for income investors in terms of long-term trends?

Mr McDermott sees managers of fixed income funds finding opportunities in subordinated European financials, emerging market debt and high-yield debt.

However, the next few years may prove more challenging for those relying on fixed income for their income needs, as Rathbones' fixed income managers Bryn Jones and Noelle Cazalis acknowledge.

“Arguably, income for fixed income managers is currently problematic, given government bond yields and credit yields have been suppressed by quantitative easing. 

“However, there are some areas of value, in particular subordinated insurance and parts of the yield curve where you can benefit from roll down. This tends to be five to 12 years on the UK curve,” they explain.

Strategy challenges

Anthony Rayner, co-manager of the Miton Cautious Monthly Income fund, agrees fixed income managers will find it increasingly difficult to deliver their income targets.

“Over the past few decades, it has been relatively easy to generate an income and capital gain in fixed income because sovereign bond yields have been falling consistently, whereas equity strategies have been relatively volatile,” he says. 

“Equity income has also been a good strategy, again, because of falling sovereign bond yields.”

He cautions: “As we move into an era of rising inflation it will be harder for both asset classes in the near term, but bond strategies are likely to be most challenged in the medium term."

Russ Mould, AJ Bell's investment director, points out there is a danger that as inflation expectations rise, they will "either drag bond yields with them or prompt a Bank of England interest rate increase, or both, potentially eroding the premium yield on offer from stocks".

He continues: "Equally, there is a risk dividends could be cut, especially as the FTSE 100’s dividend cover is thin by historic standards at around 1.6 times, when a two times cover ratio would be ideal.

"A bond-market blitz looks to be a bigger risk than dividend cuts at the moment, especially as only EasyJet, Pearson and Sainsbury's cut their shareholder payout in 2017 of late.

"But the 10-year UK gilt yield has come in from 1.64 per cent in mid-February to 1.5 per cent, and that retreat has helped the FTSE 100 by reaffirming stocks’ yield premium relative to bonds, even that comes in return for greater capital risk."

 

Source: AJ Bell/Thomson Reuters Datastream

Mr Rayner notes: “Within equity, we are finding income across geographies but particularly Europe ex UK, the UK and Asia. Within bonds, the majority of our income is generated from US and UK corporate bonds, which are very short dated.”

Ultimately, there will always be a need for income in client portfolios.

Carl Stick, manager of the Rathbone Income fund, believes: “The trends are as they have ever been, meaning as a strategy, the quest for dividend-paying shares may drift in and out of favour, as investors’ attitudes to risk waxes and wanes. 

“However, as a method for saving for life challenges in the future, whether supplementary income in retirement, future healthcare costs, or university fees, we regard an income-oriented mandate as a very important and practical solution, irrespective of the current market.”

eleanor.duncan@ft.com