Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
MOST investors fall into one of two camps: those looking to accumulate wealth by investing for growth (growing your funds so your capital pot is big enough to generate an income in later years); and those looking for investments that generate an income to help them through the present.
Age can play a determining role in which camp you fall, but there are no hard and fast rules. Nowadays, young and old can require income from their investments – whether that’s for retirement or to cover an unexpected loss in wages or a long-term illness.
Unfortunately, generating a constant income stream from our investments isn’t always an easy task. For retirees, it means nurturing our pension pots - making sure they grow enough to keep apace with rising prices over time, while also producing enough cash for us to take as income - as Tom explains in this video:
What’s challenging enough in principle has become even harder in practice. Bonds - most investors’ first port of call for income - have offered rock bottom yields in recent years, not helped by the ultra-low interest rates available on cash. Even if rates do rise next month, we’re looking at an increase from 0.1% to 0.25% - hardly enough to set pulses racing.
Dividend-paying shares, meanwhile, were hit hard by the pandemic, with many cutting or cancelling payments through much of 2020.
Income investors may be pulling their hair out. To help, we spoke to three income experts - one who focuses on bonds, one on equities, the other who manages a multi-asset fund investing in both - to find out how they’re finding income in today’s low-rate environment.
What’s happened to bonds?
Bond yields are influenced by various factors, including interest rates and inflation.
In a lower rate environment, the fixed interest you earn on a bond looks more attractive. This heightens demand for bonds and pushes up their prices. The yield you earn on that bond decreases as you pay more for it.
Similarly, bonds look attractive when low levels of inflation won’t erode the value of their fixed payments. Low inflation means higher bond prices, and lower yields.
Low interest rates and low inflation expectations have combined to push bond prices up and yields down.
Ben Deane, an investment director here at Fidelity, understands that this has made things difficult for bond investors. In his mind, the “opportunity set is still the same, yields are just lower.”
But yield is not all that attracts investors to fixed income. In Deane’s mind, two other factors have as strong a pull.
One is “downside protection”. Bonds are typically less risky than other assets like equities, meaning they shouldn’t fall as far when markets turn sour.
The other is diversification. Bonds tend to behave differently from equities (they share a “low correlation”). What affects equity markets is not necessarily felt across bond markets. That means your portfolio should prove less volatile if some of it is held in bonds as well as equities.
The combination of income, downside protection and diversification from equities, has made bonds the prime pick for your typical investor with retirement on their mind: someone who’s looking to get an income from their investments, but doesn’t have the risk appetite to maximise their portfolio’s growth potential. Income and capital preservation go hand in hand for these investors.
Are equities worth the risk?
Though bonds offer these other benefits, their low yields have pushed some income investors to look elsewhere. Many have turned to companies and funds that offer a decent dividend yield.
The problem here is that equities are usually riskier than bonds, and that could be an issue for our risk-averse income investor.
Last year served as a reminder of the risks associated with equity income investing. Swathes of companies cut or cancelled their dividend payments during the height of the pandemic in an effort to preserve cash.
Most companies have since resumed payments - in fact, global dividend payments are on track for an annual record this year - but last year came as a stark reminder of the need to be selective with your dividend sources.
If you’re an income investor, dividend cover matters - and even more so when the economic sands shift. Investors need to question what will happen in the event of a downturn, and consider the chances their income sources might cut their payments.
One way of getting around the problem is by diversifying your income streams. Investors who rely too much on the UK may be walking into a trap. Given the concentrated nature of the UK’s dividend payers, were one powerhouse to suffer a cut (a GSK or a Shell, for instance), its impact on your portfolio could be massive.
Going global could help. Funds like the Fidelity Global Dividend Fund aim to make the process easier for those investors who might find the prospect of building a globally diversified portfolio of dividend stocks daunting.
Dan Roberts, who manages the fund, is focused on that balance between providing an income and ensuring it’s sustainable. He explains that his “approach to equity investing is very much a low risk one, consistently aiming to avoid the permanent loss of capital.”
As part of his effort to manage risk, he’s more concerned with companies that can sustain their dividends than one whose yield shoots the lights out. He says: “We are looking to strike a healthy balance between an attractive yield and the quality of the company in order to ensure that the dividend is sustainable and can grow.”
As such, his fund’s focus resembles that of many bond fund managers - delivering income alongside capital preservation.
James Mee, manager of the Waverton Multi-Asset Income Fund, takes a similar approach. As a multi-asset manager, he invests in both bonds and equities.
He says: “To the extent we have had success, we believe it has come as a result of not seeking to maximise income, but rather to pay a reasonable level of income. Our focus is consistency of income, and its sustainability.”
As such, he’s reluctant to go where most investors may look for equity income: “High dividend payers typically fall into the ‘value’ bucket. We generally look for high quality companies, and so tend towards more of a ‘quality’ or ‘core’ style.”
For these manages, a company’s headline dividend figure isn’t as important as the prospects for its dividend growth. The 2020 crisis drove home a lesson that income investors should imprint on their memories: the highest yielding stocks do not always produce the best long-term outcomes.
Companies that over-zealously distribute spare cash to shareholders are likely to have little left to reinvest into the business. That could cause problems further down the line.
Look at any dividend companies or funds you hold and ask yourself whether you were attracted to the yield or the underlying business. Be wary of companies that are more fearful of disappointing income-hungry shareholders than using up cash that could otherwise be spent on capital investment.
Holding out for a dividend hero
Perhaps one of the best routes to equity income success is through the “dividend hero” investment trusts that have been able to raise their dividends, year-on-year, over a number of decades.
Source: Association of Investment Companies, 25 November 2021
Crucially, 17 of those 18 dividend heroes have been able to deliver compound annual dividend growth ahead of UK price rises over five years. That’s important for investors looking to grow their income pot.
True, their job has been made easier in recent years with inflation low. As prices begin to climb, that could become a lot harder.
Fortunately, the dividend heroes have an ace up their sleeve. Investment trusts have a unique advantage over more mainstream, ‘open-ended’ funds, in that they don’t have to pay out all the income they receive from their portfolios each year. Instead, they can hold back up to 15% and save it for years when other companies and funds struggle to pay theirs.
That proved valuable to Job Curtis, manager of the City of London Investment Trust, when the trust drew on its cash reserves to increase its dividend by 2.2% last year. Curtis told the Association of Investment Companies that 2020 was the eighth of 29 years that the trust has drawn from reserves to increase payments. It has added to them through the other 21.
Find out more about City of London Investment Trust here.
Where do we go from here?
A lot of the struggles bond investors have faced derive from today’s environment of low inflation and low interest rates. As we emerge from the pandemic, however, the age of “lower-for-longer” may be over. It’s looking likely that the Bank of England will soon increase interest rates to 0.25%. Is there a light at the end of the tunnel for income investors?
Realistically, it’s hard to know how this changes things. Interest rates might increase, but not by much. We’re likely to remain in a low yielding environment, while any oncoming inflation could well prove transitory. That means it could be more of the same for income investors.
These are difficult waters to tread, but there are options out there for you. Now’s the time to be selective with your income sources, to ensure that they’re working as hard as they can. Don’t be lured in by flashy yields or edgy markets. Income investing is a marathon, not a sprint. You don’t want to be the one to trip up halfway.
You can find out more about income investing here.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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