The decade between the end of the global financial crisis and the start of the pandemic was extremely tough for those clients with income as a priority.
Bond yields were persistently low, while most of the returns deriving from equities came from stocks in areas such as technology that had little history of paying dividends, creating the scenario whereby allocators choosing an equity income portfolio often had to choose between buying a stock with little scope for capital appreciation but a healthy yield, or else a stock with growth potential but no yield.
The pandemic period ushered in an era of rapidly rising inflation, and then rate rises, which sent bond yields soaring but also enhanced the yield offered on equities.
Vincent McEntegart, who runs the Diversified Monthly Income fund at Aegon Asset Management, says the impact of higher bond yields is that advisers are now able to place a greater emphasis on buying equities with no or little yield, but more growth potential, as the yield requirement can now be achieved via the bond exposure.
He says: “Income investors have had to work hard to capture an attractive level of income ever since the financial crisis. This was exacerbated by the final reduction in rates as central banks loosened policy. Move forward two years and the picture is materially different.
"Markets have been dominated by the twin spectres of inflation and rising interest rates. There have been widespread implications across asset classes but the dramatic reset in bond prices is perhaps the most significant.”
David Jane, multi-asset fund manager at Premier Miton, says the economic and market conditions of the past decade meant that many products that were badged as income were run on a total return basis, as fund managers did not want to operate a fund that appears to perform poorly relative to an index.
Being less reliant on equities for income offers a chance to reshape that component of the portfolio by geography, industry and theme.Vincent McEntegart, Aegon Asset ManagementThe extent of this challenge was illustrated by the Investment Association lowering the hurdle a UK equity fund needed to achieve in order to be eligible for the IA UK Equity Income sector, from 10 per cent above the index, to equal with the index on a rolling three-year period.
That action was prompted by a number of the best-performing, in total return terms, UK equity income funds being unable to hit the previous target.
McEntegart says: “Being less reliant on equities for income offers a chance to reshape that component of the portfolio by geography, industry and theme.”
He adds: “Low average yield from the US equity market is no longer the issue it was. Instead, its growth potential is something that can more readily be tapped. It would have been difficult to own companies like Microsoft (developing artificial intelligence and holding a 49 per cent stake in ChatGPT) and Broadcom (a global leader in semiconductors and infrastructure software) when income was scarce since they yield less than 1 per cent and 2 per cent respectively.”
Diversification
Jordan Sriharan, multi-asset manager at Canada Life Investments, is another who has felt able to stretch his wings a bit when constructing an income portfolio.
The mandate he runs has an income target of 4 per cent, which is paid out monthly, and in 2023 he reduced his equity allocation by between 10 and 15 per cent, instead deploying the capital into investment-grade bonds.
He says with bond yields sufficiently high, he was able to focus the equity portfolio on stocks with what he believes to be greater growth potential.
Sriharan acknowledges this lower equity allocation may mean he misses out on some stock market growth in the comping period, but says he feels that the economic outlook is sufficiently murky that the level of sacrifice may be quite small in an income portfolio.
From a diversification point of view, McEntegart says the previous hunt for yield from an equity allocation forced investors into having higher levels of exposure to some markets, such as the UK, than they might otherwise have wanted to, but if they use corporate bonds for income they can move between a broader range of equity markets and sectors.
Darius McDermott, investment adviser to the VT Chelsea multi-manager fund range, is another who has upped the exposure to bonds in his income portfolio following a period where they yielded little.
These are powerful arguments for a mixed asset approach to income generation.David Jane, Premier MitonBut when it comes to creating his equity exposure, McDermott says his aim is to be “diversified by market cap, geography and investment style, with growth and value funds in the portfolio".
He adds: "We also own Asian, European UK income funds, and some small cap funds, and a pair of global equity income funds, M&G Global Dividend and Guinness Global Income.”
Premier Miton's Jane says: “In the long term, you might expect equities to outperform fixed income, so you tend to be a seller of equity over time to maintain the asset allocation balance. These equity gains are in effect reinvested to increase the more stable, bond income stream.
"As we do not run an income style fund, we own at various times a fair amount of non-dividend paying growth stocks. Gains on these can be regularly reinvested into higher yielding, more mature equities. The key is a consistent and growing income stream from the fund as a whole.
"When equities are weak relative to bonds it is often the case that bond yields are relatively low, so we can reduce bonds in favour of higher yielding equities. These are powerful arguments for a mixed asset approach to income generation.”
Stock selection
Ben Peters, who runs the Evenlode Global Income fund, says a bond portfolio tends to have assets with different durations to maturity, so he likes the dividend-paying equities he owns to be at “different levels of maturity, as generally speaking companies that are more established are more likely to pay out a lot of their income in dividends, but you also need growing companies that have the capacity to increase their dividends in future”.
He says one of the challenges with owning some of the most mature companies is that while the yields are potentially very high, there is a risk that lack of growth from those companies risks future dividend cuts.
David Thorpe is investment editor at FT Adviser
