Multi-assetApr 9 2020

Building a defensive income stream

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Building a defensive income stream

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.

Among the companies with the greatest payout ratio are banks, who are now forbidden by the regulators from making payments this year

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.

"They have the cash for dividends. One of the problems investors will face is that some of the more high yielding companies are the more economically cyclical ones, the ones that may need cash from the government.”

Data compiled by fund house Octopus shows that UK equity income funds are over-reliant on a small number of stocks to provide income. 

Mr Jackson says the current climate means investors need to focus more on the risk of a dividend not being paid, than simply on the size of the payout.

To combat this, he says the income fund on which he works holds a very large number of different companies in the portfolios.  

Mr Morris says the situation is so stark that “dividends may not be something that we can think about this year, they may be over.” 

Alternative sources of income

Mike Coop is responsible for the income portfolios at Morningstar. 

He says the traditional areas of safer income for investors include real estate investment trusts (Reits), and infrastructure assets such as toll roads. 

Mr Coop says a problem with these assets right now is that “landlords are being asked to take a share of the pain” in terms of the economic downturn, with tenants unable to make rental payments.

Mr Flood is looking to assets that have many of the characteristics of bonds but a higher yield.

He invests in renewable energy and infrastructure assets, as the cash to pay the income on these ultimately comes from the government via subsidy, so has an element of security, and has a higher yield than the bonds offered by the same governments.

He says another advantage of those assets is that the rate of return is inflation-linked, so offers a protection that bonds do not. 

Mr Watson is also keen on these assets, describing them as a “real diversifier of income.”

Ian Reese, a multi-asset fund of funds manager at Premier Miton Investors says: “All too often, ‘reaching for yield’ involves taking a higher level of risk than is warranted and is most vulnerable to future cuts to income when they run into road bumps.

"For our equity selections, we favour managers who run a disciplined income approach.

"That is, managers who invest in companies that can either sustain or grow their dividends over time so as to provide an income outcome for their investors.

"It is no surprise to us that one of the longest serving managers in the UK is Colin Morton of Franklin Investors.

"He has been at the helm of his UK Equity Income fund for 25 years and is one of the most consistent performers amongst his peers by an approach that deliberately seeks to grow the income being generated by the portfolio over time.

"Such a manager has been a core part of our mix for many years.”