By STEPHEN MARRIOTT 31/03/2009
With base rates at 0.5%, those who rely on income from assets are finding it unrewarding to hold cash or government bonds. The best instant access cash account rates are around 3% (gross). To get better returns investors need to lock their cash away for longer. Even then returns are still low. There are a couple of fixed-term cash ISAs yielding 3% and short-term gilts offer a gross yield of between 3.1%-4.8%.
To protect income and purchasing power, investors have to take on more risk. The traditional alternatives are corporate bonds, equity income funds and property.
Corporate bonds
Corporate bonds offer the most attractive risk / reward characteristics of any asset class. Distressed selling in the sector has resulted in yields on investment grade corporate bonds of approximately 7%. These yields and high spreads (3%) relative to Government bonds highlight the extra risk and the possibility of a high level of defaults.
Such spreads represent an unrealistically negative world view, implying a depression much worse than the 1930s. A diversified approach to the asset through bond funds is recommended and we suggest Fidelity Moneybuilder Income, Invesco Perpetual Corporate Bond and M&G Optimal Income.1
Equity Income
Equity income funds are more risky but are the best way to achieve a growing income. At the moment it’s possible to achieve a net yield of around 5.5-6%. Dividends make a major difference to overall stockmarket returns because fund managers target those companies they believe can grow their profits and can pay an increasing dividend. The Barclays Equity Gilt 2009 study demonstrates the power of dividends over the very long term. It shows that £100 invested in equities at the end of 1899, with dividends reinvested, could be worth £1.15m or just £9,129 without income reinvested.
Dividends are not guaranteed and in times of recession they are under threat. For example in the recession of the early 1990’s all sectors with the exception of pharmaceutical companies cut dividends. With the collapse of the British banking system and the current recession we’re already seeing a swathe of dividend cuts. Merrill Lynch forecasts average dividend cuts for 2008 of 29% and 1% for 2009 but there are still some stalwart companies offering attractive dividends.
The universe of reliable dividend payers has been reduced and it’s more important than ever to pick those equity income fund managers with the best record of growing their income. Many of our recommended funds should hold up better than most, although some of our managers have indicated they expect their yield to fall by up to a third of a percent in 2009. For example, Colin Morton manages Rensburg UK Equity Income: a £10,000 investment in the fund from January 1995 to the end of 2008 would have resulted in cumulative dividends of £9,801. Karen Robertson, manager for Standard Life UK Equity High Income has returned £4,927 in dividends on £10,000 invested from 1998 to 2008. Both funds currently have net yields of 6.4%2 and 5.3%2 respectively.
Enhanced Income
In addition to conventional types of equity income funds there are now some specialist funds which take advantage of dividends and use derivatives strategies to enhance yield. Schroder Income Maximiser (rated 4 stars) invests in blue chip stocks and enhances yield by ‘writing’ options on the stocks in its portfolio which produce premiums. This reduces capital growth and increases risk. Note though that the level of premium income is not guaranteed and will vary according to market conditions. However, as part of a balanced portfolio it is a worthy fund, especially as it’s currently yielding 12%. We expect to see more of these “covered call” funds come to the market this year. In fact BNP Harewood Enhanced Income has recently launched and has a gross yield of 8%. It has been awarded three stars by Bestinvest.
Commercial Property
Commercial property is still an important income provider when held over a whole investment cycle but the shorter term outlook for property remains negative. The prospect of tenancy defaults, closed credit markets and forced sellers continue to pile pressure on the market. Consequently, despite headline yields of just over 7%, we expect further weakness in the year.
That said we have started to see some evidence of interest in prime stock at close to 8% yields, and we could be close to the point where the property sector is factoring in much of the bad news. More recently, a round of rights issues to strengthen balance sheets has put further pressure on share prices and average share price discounts to net asset values now stand at around 50%. Current prices for those investors willing to take a longer-term view might prove to be an attractive entry point but given our negative stance we would encourage such investors to look at the blue chip end of this market. Land Securities and British Land currently yield 14.8%3 and 7% respectively. Both of these stocks are core holdings in TR Property Trust (5 stars), a diversified closed ended property trust investing directly both in property and real estate shares which is currently yielding 5.4%.
1Differences remain between these bond funds in terms of their underlying investment objectives and structural constraints.
2Yield figures are historic and are provided by the underlying fund management group and reflect distributions declared over the past twelve months as a percentage of the mid-market price of the fund.
3Land Securities has announced a rights issue so we would expect these yields to fall once this has been completed as the yield is based on historic dividends per share.