Investing for income in 2014

26th December 2013

Investors who are primarily seeking income are set to face very similar challenges in 2014. They also face similar dilemmas balancing income and risk to capital given the difficulty of making a solid prediction about the timing if not the ultimate direction of interest rates.

Investment journalist Cherry Reynard examines the issues.

The income from bonds may have moved slightly higher, but with no sign of a tick-up in interest rates, a significant rise still looks unlikely. Equally, valuations in some equity income areas are stretched and investors are paying a lot for reliable yield. In the meantime, alternative sources of income, such as those available from some investment trusts, have also been widely ‘discovered’ by investors. What are the options for 2014?

A key point is that risk tolerance is likely to guide an investor’s income selection. Robert Burdett, joint head of F&C Investments multi-manager team, says: “The income gap is now so low – high yield bonds provide an income 5-6%, while equities give 3.5-4% – the real decision is about risk tolerance.

If investors are worried about interest rates going up, they would be better off holding some equity, some cash and a bit of property. If their worry is deflation, they might be better off with a bond and equity mix.”

Equally, in the prevailing environment diversification is likely to become very important. In addition to conventional bond and equity funds, Burdett said that he includes funds such as the Darwin Leisure fund (which invests in caravan parks), Medicx (which invests in doctors’ surgeries) and infrastructure funds to provide diversification across the group’s portfolio.

Income investors are likely to need to make a decision on whether they are going to invest in bonds in 2014. It remains an unpopular asset class. Fixed income markets are largely in thrall to monetary policy in the US. Any hint of a reduction in US quantitative easing – however inevitable – is likely to be interpreted by the bond markets as “interest rates are going up”. Equally, bonds tend to do badly at times of economic expansion and potential inflation and with most pundits predicting a year of good economic growth in 2014, this is also likely to present a risk for fixed income.

Adrian Lowcock, senior investment manager at Hargreaves Lansdown, says: “In fixed income, investors’ capital will not be protected and therefore they have to be careful where they find income. The so-called ‘great rotation’ from bonds to equities hasn’t happened in 2014 and this will exert pressure on fixed income markets.”

Some are predicting an even more dramatic outcome in fixed income markets. Trevor Greetham, head of asset allocation at Fidelity International, says that the US 10 year treasury may have another 10-15% to fall from here, having already fallen 10-15%. Few investors would see that as a low risk  investment.

In general, government bond markets are not favoured. Gavin Haynes, investment director at Whitechurch Securities, says: “We see little value in holding UK gilts given that they offer a yield struggling to beat inflation. We believe that you need to be very selective as to where to invest within this asset class in an improving economic backdrop.”

The majority of bond fund managers come out in favour of strategic bond funds, where the decision on which type of bonds is made by the manager: “Strategic bond funds with a flexible remit give fund managers the opportunity to adjust to the changing climate” says Haynes.

Nevertheless, if investors want to be more nuanced, he continues to favour high yield corporate bonds, which should do well in a more positive economic climate. In addition, although inflation is not a problem in the short-term, he also recommends some exposure to index-linked bond positions to provide inflation protection.

Tom Becket, chief investment officer at Psigma, throws a contrarian choice in the mix when he selects the Aberdeen Short Duration Asian Bond fund as his top pick for fixed income investors in 2014. He says: “There have been two things to avoid in 2013; sovereign bonds and Emerging Market currencies. This fund invests in both and produced a mildly negative return this year. However, we believe that the future might be better and now could be the time to back emerging market currencies. There is extreme negativity around the short term outlook for EM currencies, but with many of the Asian economies stabilising, we expect better performance.”

However, the majority of fund selectors believe equities are a better place to hunt for income. An improving economic environment should feed through into corporate profits while payout ratios for companies remain relatively low and provide room for manoeuvre. However, Lowcock issues a number of caveats, saying: “Prices in some areas have got a bit ahead of themselves.” He also says investors need to ensure they are diversified, perhaps looking beyond conventional UK equity income funds, to Asian and Emerging Market funds.

Burdett agrees, saying he is taking exposure to global and regional equity funds to provide diversification to his equity income holdings. He is also looking for those managers targeting dividend growth rather than a high level of absolute dividends as the global economy moves into an expansion phase. Managers falling into this category might be Matt Hudson, manager of the Cazenove UK Equity Income fund, or Mike Kerley, of the Henderson Far East Income trust.

Some multi-managers are being more conventional, however. Becket at Psigma picks Artemis Income, while acknowledging it is an ‘obvious choice’: “After the massive re-rating of small and medium sized companies in the UK market over the last few years, we are starting to look back to the under-valued and unexciting mega-caps for the best opportunities. Held back by the recent strength of sterling and the relative lack of exposure to the ‘rampant’ UK economy, mega-caps have continued to underperform.

“This has left many looking cheap, including excellent and understated long term growth opportunities in the pharmaceutical sector. The new and undisputed ‘Kings of Income’, Adrians Frost and Gosden, agree with us. They also allow themselves the flexibility to invest in sectors like banks, which other income managers lazily brand ‘uninvestable’, and mining, ‘not enough yield’. While

UK equities are a boring choice, anecdotal evidence suggests a return to favour from international investors, and income-stressed investors could drive a re-rating of the big income plays.”

The final choice for income investors will be on commercial property. The property equity sector has largely recovered, but bricks and mortar property funds have lagged. The sector draws mixed views.

Greetham believes it could be dragged down by rising bond yields, but plenty of multi-managers such as Ryan Hughes at Apollo, hold the opposite view and have reallocated to the asset class in 2013 as this article from trade website Money Marketing suggests. The debate appears to come down to liquidity, so investors will have to decide whether the higher yield merits the liquidity risk.

There will be no free rides for income seekers in 2014, as interest rates and bond yields remain relatively low, but diversification is likely to be an investor’s friend.

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