Income under threat from rate rises and inflation

Income under threat from rate rises and inflation

The monetary easing policies among central banks spurred investors to seek income but managers have warned income hunters may face fresh challenges as interest rates climb and inflation makes a comeback.

“The increasingly desperate hunt for income can largely be traced to the huge distortion in the market caused by quantitative easing (QE), which has boosted asset prices and compressed yields,” explained Andrew Morgan, portfolio manager of Alpha:r2 at Walker Crips.

“As a result, many investors see regular equities and bond markets as overvalued, and are disappointed by their income levels. 

“Investors also worry about what will happen as QE unwinds. With interest rates close to zero, bond capital values are likely to be hit as rates normalise.”

The US Federal Reserve hiked interest rates to 1.75 per cent from 1.5 per cent at its meeting on 21 March, and is expected to make another three to four increases this year, led by new chairman Jerome Powell.

But the Bank of England, at its Monetary Policy Committee meeting a day later, confirmed it would hold the interest rate at 0.5 per cent.

Inflation has crept up in the UK, to hit 3 per cent, although it came back down to 2.7 per cent in February this year.

Anthony Rayner, co-manager of the Miton Cautious Monthly Income fund, said it would be more difficult for both fixed income and equity income to deliver on income targets against this backdrop.

“Over the last 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 explained. 

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

“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.”

Rob Argent, portfolio manager for Allianz Global Investors, observed: “Given the prospect of rate normalisation and increasing inflation expectations, it is a challenging time for income investors.

"On the fixed income side, it can be difficult to achieve inflation beating total returns without moving further out on the risk curve.”  

He also warned: "Funds that offer exposure to the most liquid, sterling denominated, investment grade corporate bonds are attractive, given their historically stable performance and yield pick-up versus government securities the recent spike in market volatility shows signs of market complacency."

Ashley Owen, associate director for financial planning at London-based AES International, said advisers need to understand clients’ tolerance for risk.

“Their risk tolerance will dictate which assets classes could be appropriate for their income producing investment portfolio,” he explained.