A decade of record low interest rates, high inflation and volatile equity markets has created a challenging environment for income-seeking investors.
With increased appetite for predictable, stable returns and reduced investor demand for traditional financial products such as government bonds and listed equities – which are failing to deliver – it is more important than ever that financial advisers consider all investments and asset classes that can generate income for their clients’ portfolios, without adversely increasing their exposure to risk.
Investment trusts
One option for investors seeking income, which has proved particularly popular over the years, is investment trusts.
New research shows that the number of higher-yielding trusts has increased by tenfold in less than a year, with almost 10 per cent of investment trusts yielding at least 4 per cent, and some offering dividend yields as high as 6.3 per cent.
Investment trusts are attractive compared with some other alternative investment options, because they are highly suited to holding assets such as property and infrastructure, allowing for diversification.
Investment trusts also have a unique advantage in that they can hold back some of the income they receive – up to 15 per cent – creating revenue reserves.
This gives them flexibility to smooth their dividends and increase payments in years that are particularly volatile, or when income has fallen or is flat.
However, investment trusts are traded like conventional shares and will therefore typically incur trading costs and stamp duty on purchases, eating into returns, and they can trade at both a premium and discount to their net asset value.
P2P lending
The weak interest rate environment over the past decade has fuelled investor demand in the search for yield.
This, combined with traditional banks’ reluctance to support small and medium-sized enterprises in the wake of the financial crisis, resulted in the emergence of peer-to-peer lending – the practice of lending money to individuals or businesses through online services that match lenders with borrowers.
The market has erupted from a standing start in 2010, with recent figures putting the total funds borrowed by SMEs at £10bn.
On the supply side, Connection Capital found a quarter of high net worth investors are now allocating at least one-fifth of their wealth into assets such as P2P lending.
With inflation-beating interest rates, which are commonly advertised at the 4-8 per cent a year mark, the reasons for investor demand are clear.
The product has evolved and P2P platforms have been eligible for inclusion in the Innovative Finance Isa since 2018, making it more attractive to investors.
But more recently, growing loan defaults have increased the risk of investing in P2P platforms, and questions are starting to be asked about its viability in the future.
A number of platforms are experiencing far higher default rates as they mature – Zopa’s expected default rate of 4.52 per cent is higher now than at the start of the financial crisis, while Lending Works’ predicted default rate of 3.4 per cent is more than double the rate when it started lending in 2014.
The P2P sector is regulated by the Financial Conduct Authority, which last year announced a review of the sector.
So while P2P may still fit the risk/return profile for more sophisticated investors, and may be sensible for smaller investments as a stable and predictable means of generating income, the risk profile has certainly increased and investors may want to look elsewhere for less volatile income plays.
Direct lending: A predictable alternative
Another alternative option, which carefully balances risk with reward, and one that has become increasingly popular over the past few years, has been to invest in funds managed by specialist credit teams that are responsible for lending directly to small, growing businesses.
These funds provide asset-backed exposure to a large, diversified portfolio of UK SMEs operating across a broad range of sectors. The financing includes loans, leases, working capital and receivables finance and project finance, among others, all of which differ in size and in loan terms.
In my view, they provide a fixed-rate, predictable income stream that is uncorrelated to traditional listed equity and bond markets.
Such funds can be a good way to diversify investment portfolios. Volatility in the direct lending sector has been low when compared to traditional capital markets, with the returns stable through market cycles, relative to equity indices.
Direct lending also brings with it a number of protections as part of the rigorous due diligence process that is undertaken before a loan is made, adding another layer of investor protection.
For investors looking to build a balanced portfolio that provides them with dependable returns over a fixed term, combined with the low-risk profile that is not so easily found in emerging alternative investments, direct lending can be a considered choice.
Key Points
- Investment trusts are one option for clients seeking income returns
- P2P is another, albeit riskier, option for income seekers
- Direct lending, managed by credit teams, is another option
Belinda Thomas is a partner at Triple Point
