By ADRIAN LOWCOCK 30/06/2010
With cash accounts yielding close to zero, many investors have found themselves gravitating towards other asset classes offering higher income yields. However, as we have seen with BP over the last few months, these involve far more risk to capital, so in this article we have taken a fresh look at the downsides.
Many investors require income to meet current expenditure, but we caution investors against chasing yield too aggressively as an objective. Investors should be more mindful of the total return their investment strategy is providing and draw down capital if necessary to meet expenditure requirements. Fund supermarkets now usually allow investors to specify a level of monthly or quarterly cash withdrawal, using disposals to supplement income they receive, when necessary.
Sovereign bonds
There has been a rush towards ‘perceived quality’ as investors have shunned the more fiscally irresponsible governments. We expect some countries to default eventually. The other risk on the horizon is a sustained upsurge in inflation, but our view is still that this should not be a problem in the short term.
Quality corporate bonds
These are traditionally the anchor for many income portfolios. The interest margin over gilts for quality bonds has widened since April, as investors have begun to focus more on the prospect of contagion from the euro sovereign crisis and the likely impact of this on the asset class. However this has been offset by a fall in gilt yields, so that corporate bond yields are broadly unchanged. Expected yield: 5.0%.
High yield bonds
The yield on high yield bonds has recently risen as investors concerns about euro sovereign debt issues have led them to question the growth outlook. In the meantime, companies are reporting that operating fundamentals are still strong and rating agencies are predicting default levels will settle at 3-4% by the year end. The main risks remain a double dip recession or a decrease in risk appetite. Expected yield: 8.0%.
Commercial property funds
These funds often carry approximately 15-20% in cash to meet potential redemption requirements, which in itself acts as a drag on returns. Values have recovered strongly in the past year, partly due to restricted supply. We expect some moderation of this trend, as banks seek to divest themselves of property assets in the year ahead. Expected yield: 4.6%.
Equities
Historically, equities have a good track record of growing dividends above the rate of inflation. In the current environment, strong corporate cash flows, near record profit margins and reasonable dividend cover also mean the outlook for dividend increases is gaining more positive momentum, particularly where companies are in a position to raise their top line. By historical standards, UK equity valuations are not demanding. We estimate typical yields on UK equity income funds are currently about 4.0% (even after allowing for BP suspending its dividend). The UK equity income market is skewed towards a small number of very large global companies, decent levels of income are also available from funds investing in global equities (4.6%) and the Far East (4.2%).
Recommendations
If there is anything you wish to discuss regarding this article, please call one of our Investment Professionals on 020 7189 9999.