Bonds are not the only path to investing for income and yields are not the only consideration. Portfolios need to be constructed to meet specific objectives and should be as efficient as possible both in terms of tax and riskiness. Here are just three considerations that any income investor might reflect upon before investing.
Diversify
Like any other portfolio, investments for income should be diversified, giving exposure to instrument types and sectors. Indeed, diversifying risk might be seen as especially important in an income portfolio since you may be reliant on the regular payments. Bonds are especially attractive to those seeking income because their fixed income nature reduces uncertainty and are considered low risk. There are also a number of specialist income funds which invest across a spectrum of instruments. Some are discussed in other articles in this review and there are details of others on the Selftrade website. But these are not the only instruments capable of returning solid revenue.
Equities themselves are often overlooked and yet a number of sectors offer especially good yields. Traditionally, utilities such as water and power, which by their nature enjoy lower if steady growth, pay attractive dividends. But more recently higher growth sectors, such as banking, have been notable for their yields. This is a reflection of not only historically low price earnings but also a ratings compression leading to similar ratios for different sectors and consequently more similar yields. Always check the dividend cover (the number of times the dividend can be paid from earnings) on unusually high yields. Remember, if it looks too good to be true…
Elsewhere, Real Estate Investment Trusts (REITs), discussed in February’s Stocktake, give investors exposure to property returns and potentially good income. Although property companies converting to REITs in the new year offer remarkably low dividends (British Land is around 2% and Land Securities 2.3%), REIT rules, which require that at least 90% of earnings are distributed, mean that future issues should be more attractive in this respect.
Don’t be ravaged by inflation
It is easy to get carried away with the yield of an income investment over the longer-term, ignoring the position of your capital. The great bane of income investors is inflation, which erodes the real value of savings. In March, UK inflation as measured by the consumer price index rose to 3.1% with the wider retail price index showing a rise to 4.8%. This eats into cash kept safe under the mattress, reducing its purchase power. But so too does it eat into the value of capital from which an income is derived. Consider that £10,000 invested in an instrument designed to return capital in full, will have a real value of just £6,000 after a decade were inflation to remain at 5% (indications are that it should return closer to the 2% target). It is important, even in a portfolio constructed to produce income, that capital at least keeps pace with prices. Indeed, the longer you are likely to need the income portfolio, the greater the need for capital protection.
Exposure to equity in a portfolio can help to protect against inflation as well as provide income, although it can also increase volatility. Using collectives such as investment trusts can help to balance the portfolio here and there are a number of good income and balanced products available. A number of unit trusts and OEICs are designed to extract a growing income from a pool of shares including Schroder’s new Global Equity Income discussed elsewhere in this issue.
For those who want to stick with bonds, there are index linked gilts whose value and payments are linked to the rate of inflation. However, while providing an effective hedge, returns can be relatively low.
Think laterally – time to reassess zeros?
Income, of course, attracts income tax. Using tax efficient shelters such as ISAs and PEPs can go some way in mitigating against this, making your portfolio tax efficient. But many people who rely on their investments for earnings do not use their annual capital gains tax allowance (currently £9,200) and this might be an oversight given instruments such as zero dividend preference shares. Although called ‘zero dividend’ and indeed paying no income, this product is useful for income investors. Zeros are one class of split capital investment trusts which are designed to separate income and capital growth. They are attractive because they pay a fixed capital return on maturity equivalent to a fixed accumulating rate of interest. But, being capital gains, attract CGT rather than income tax.
This is a sector which has shrunk in size and popularity since its crisis back in 2000 when bank debt introduced into the instrument range and unwise cross-investment caused a number to implode when markets fell from their late 1990s highs. The listing and circularity rules have been tightened to prevent a reoccurrence and the sector has since enjoyed a strong performance as can be seen from the Association of Investment Companies Split Capital Trust Index reproduced below. Indeed, not all splits were guilty (in 2001 about 45 of 140 experienced problems of which 27 saw their shares suspended) but the reputation of the sector as a whole was tarnished, leading to poor liquidity for a time. What the episode emphasises is that investors should always do their homework however ‘safe’ the instrument class is reputed to be. One good indication of quality is the hurdle rate which is the return the trust needs to achieve each year – historically set very low – to ensure the zero pays in full.
| AIC Split Captial Trust Index |
|
|
|
|
1 Year |
3 Years |
5 Years |
| Zero Dividend Preference |
105.7 |
138.0 |
155.1 |
| Income |
116.6 |
196.3 |
157.7 |
| Ordinary Income |
122.9 |
236.1 |
170.1 |
| Capital |
128.2 |
295.5 |
312.6 |
|
|
|
|
There are many other considerations and approaches to constructing and income portfolio but the key points here are to keep it diversified and tax efficient. Make use of the numerous products available and ensure your investments are suited to your ongoing requirements.
You can read more on the topic by downloading The investment review Stocktake available from the Research Section of the Selftrade website www.selftrade.co.uk.