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Reflections – Brian Tora looks at the changing face of generating investment income

Once upon a time, investing for income was a relatively simple matter, says Brian Tora. If only it was quite that simple now


It wasn’t that long ago that the UK Equity Income sector, which contained funds run by a wide range of so-called “star” investment managers, could demonstrate a long history of delivering a rising income together with capital appreciation. Many of these funds were amongst the top performers across a range of sectors on a total return basis. Then, a decade or so ago, it all turned rather sour.

The trigger was the banking collapse here and abroad, followed by the global financial crisis and the disaster that hit BP in the Mexican Gulf. You’ll remember that banks and BP were amongst the largest dividend payers in the FTSE 100 Share Index. Not only did this source of income suddenly dry up, but capital values were hit as a consequence. Many hitherto consistently good performing managers were hit hard by this debacle.

Cheap money

The period of ultra-low interest rates this ushered in created another opportunity for income seekers. Bonds became flavour of the month and new funds run to a range of investment strategies started to spring up. As central banks’ quantitative easing programmes pushed cash into the system, often through buying bonds, capital values were enhanced also and the relationship between equities and government bonds underwent a fundamental change.

Mind the yield gap

Until the 1950s, equities yielded more than gilt-edged securities to reflect the perceived additional risk they contained. The difference in the income generated by government bonds and ordinary shares was known as the yield gap. But pension fund managers, led by George Ross-Goobey, started to back equities on the basis that well-managed companies could increase the dividends they paid to shareholders on a regular basis and thus provide a hedge against inflation.

And the reverse yield gap

By the time the 1960s arrived, equities were trailing gilts in the income stakes and the reverse yield gap became firmly entrenched. Until shortly after the financial crisis, that is. With bond values driven higher and the appetite for risk diminished, bond yields fell below those available on equities. Moreover, lower interest rates depressed annuity returns which are used to determine pension fund liabilities. This led to a widening of pension deficits and a generally more cautious approach to investing from pension fund managers.

All change

Nowadays, of course, it all seems to be changing again. Monetary tightening is back on the agenda for central banks and interest rates are on the up. So, too, is inflation. Bond yields are trending up, with all the consequences this must have for their capital values. In the United States, ten year Treasury bond yields have been nudging 3% – not far short of double what they are here. And if inflation continues above the 2% target in the UK, the Bank of England may be forced to raise rates faster than expected as indeed was highlighted in a recent Bank of England statement. Many experts are predicting the next UK base rate rise might happen as early as May.

Where might the money flow?

All of which makes life particularly tricky for the income-seeking investor. The good news is that the range of income producing assets has widened considerably over the years. Today it is comparatively easy to gain exposure to commercial property, an asset class that was the province of the seriously wealthy alone until relatively recently. Similarly, infrastructure investments are available through professionally managed funds, while more esoteric assets, like private equity and venture capital, may have their place in some incomeaccented portfolios, but only if the investor is prepared to accept the additional risk they can represent.

Utilities, which once were viewed as the cornerstone of an income-seeking equity portfolio, are looking more like a potential political football. This serves as a reminder that conditions can – and do -change in the investment world.

What about equity income funds?

If interest rates are to continue to rise and inflation remains above target, the argument for equity income funds will receive a boost. No-one is expecting a return to excessively high rises in the cost of living indices or double-digit yields on government bonds, but perhaps cash, which has delivered such poor income returns (well, it has delivered negative real returns in truth) for some time now, may find a place back in income portfolios.

As for equity income funds, it is not just the UK where investors and their advisers need to consider these days. Many global markets now offer access to higher yielding equities through professionally managed funds. Bond funds are more difficult to assess, though again the variety of investment styles and underlying assets suggest that there will be something for everyone, depending on needs.

Diversification is key

In the end, the sensible adviser is likely to assemble a range of different funds covering a myriad of underlying assets to address a mandate of producing a reasonable income for their client. While the short term direction of interest rates and inflation seems set, there are sufficient uncertainties out there to ensure that hedging your bets remains no more than prudent.

But I have to confess that I am encouraged by the findings of the Barclays Equity/Gilt Study, which confirms that equities are most likely to produce the best long term total return.

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