Building a defensive income stream

This article is part of
Guide to defensive multi-asset investing

Building a defensive income stream

Clients living longer at the same time that interest rates are at record lows presents a problem for advisers who clients are entering the decumulation phase of their investment lives.

Lower interest rates mean the value of the income that can be earned from government bonds, and of annuities, two of the traditional, lower risk sources of income, has been reduced in recent years.

This leaves advisers with the option of either managing the clients' expectations about the level of income that is now achievable, or take extra risks in portfolios to generate the yield necessary. 

Is equity income possible?

Perhaps the most logical way to get a higher yield is to buy more of the higher yielding equities in the UK market.

But among the companies with the greatest payout ratio are banks, who are now forbidden by the regulators from making payments this year, and oil companies whose dividends will be under pressure as a result of the much lower oil price.

Meanwhile, the policy in the UK to use quantitative easing pushes down the income available on safe haven assets, making it harder to avoid an allocation to equities. 

The extent of the puzzle facing income investors can be seen in the fact that a client wanting a 5 per cent yield in retirement, might once have expected to be able to deploy capital into UK government bonds, and received between 2.5 and 3 per cent of the required amount, with the remainder to come from equities.

UK government bonds presently yield 0.3 per cent, meaning a yield of 4.7 per cent from equities. 

Andrew Cole, multi-asset investor at Pictet says that dividends are naturally under pressure in a recession, and this creates a challenge for income investors.

But, he adds, the policies introduced by the government mean that even as the economy recovers and some companies generate greater profits, the outlook for dividends will not revert to the normality.

Mr Cole says: “The measures by the government [to pay 80 per cent of the wages of furloughed workers] mean that in time the government will want that money back.

"Now the government will subordinate the bondholders and the shareholders, that is, the government will get paid first.

"And that will leave less cash for shareholders, so dividends will continue to be under pressure.

"Some companies won’t, even if they are generating more cash, be able to repay the government straight away and so the government will take a stake in those companies, which disadvantages the shareholders.

"We don’t run funds for income in our multi-asset team, and I would say that if a client doesn’t want to put capital at risk now, don’t invest for income.

"The stocks we have that pay dividends are those with little debt, many of them are large technology companies, they have been making money for years and have often used the cash to grow the company.