SECURING A SUSTAINABLE INCOME
With bond yields remaining at historic lows and the equity bull market exceeding 100 months – long relative to history – how can advisers secure sustainable income for clients?
M&G Property Portfolio fund manager Fiona Rowley points to UK commercial property as a sustainable source of income.
She typically holds a mix of prime and good secondary assets, which tend to be higher yielding assets, reflecting the additional risk of owning them. In light of current political and economic headwinds, she has been increasing exposure to prime property over the past year to provide greater security of income and holds a higher cash balance than normal.
Nevertheless, over the next five years she expects rental income to average 5% per year and continue to make up the bulk of total returns.
Over the past 30 years, rental income has contributed more than 70% of the overall return from UK commercial property. More recently, over the past decade, the return from rental income has exceeded the total return, as capital values are lower than they were ten years ago.
In an environment of mid-single digit total returns, maximising income is crucial, which M&G does through a combination of a low portfolio vacancy rate and asset management initiatives.
“We are always working hard to reduce vacancy rates and hence improve an asset’s ability to generate income,” she says. “For example, leasing vacant properties on a floor-by-floor basis, as opposed to letting the building to a single tenant can speed up occupancy.
“And, while leasing wholly or partially vacant properties is a priority, asset management activity is an important way to enhance returns. Agreeing new lease terms usually leads to higher rental values, which in turn boosts capital values.”
Vincent McEntegart, an investment manager in Kames Capital’s multi-asset team, suggests looking beyond single-asset income solutions.
“We recognise that advisers are faced with a complex backdrop for allocating client assets; generating sustainable income for clients at an acceptable level of risk is a challenge,” he says.
“A multi-asset solution can help meet this challenge. By looking beyond traditional sources of yield investors can achieve a broad-based sustainable income, while diversifying risk and avoiding reliance on a single asset class.”
The Kames Diversified Monthly Income fund, for example, targets a yield of 5% from more than 200 sources of income and has a current projected yield of 5.4%.
The ability to seek value and income across assets as market conditions evolve is a key advantage for active multi-asset income funds over single-asset peers.
“This approach allows an evolution of asset class exposure over time, creating a blend of income-generating assets,” he says. “We believe that volatility presents opportunity, and flexible funds can take advantage of this, accessing sources of yield at attractive prices.”
He currently favours listed alternatives and property. The fund’s listed income-generating assets include asset leasing (aircraft), renewable energy (wind farms) and listed infrastructure (schools, hospitals and roads), and collectively contribute almost one-fifth of the yield. Real estate, meanwhile, represents the maximum single asset class contribution of 0.82%.
“A blend of these assets can reduce risk at a portfolio level, and provide an attractive, diversified income stream,” he says. “We particularly like their often contractually-backed cashflows, and low correlations to other asset classes while offering appealing levels of income.”
ALASTAIR GUNN AND RHYS PETHERAM
JUPITER ASSET MANAGEMENT
Alastair Gunn and Rhys Petheram, managers of the Jupiter Distribution fund, have been looking overseas in their search for income opportunities.
“Everyone is on the look-out for ‘safe’ sources of income and has been for a long time; equities are being re-valued just like bonds have, and investors have to buy a high valuation for anything that has a secure income stream,” says Alastair.
“The pressure remains on for fund managers to find sustainable income that is, ideally, both attractive and growing.”
Interpreting the business cycle is a central part of the duo’s investment process, as they seek to ascertain whether the equity or bonds of a company are likely to be most attractive.
“We feel that many sectors in the UK are currently getting to a late stage in their business cycle, meaning there is more exuberance and valuations rise,” says Rhys. “In this phase the risk/return profile tends to favour equities more, with more M&A [mergers and acquisitions] and share buybacks.”
The fund managers have been buying international equities and initial public offerings, and have been more prepared to buy lower-yielding stock than they might previously.
“We’ve been willing to accept a lower starting yield if we can see that the company has a track record of paying special dividends and have confidence that this can be sustained,” says Alastair.
“Often the trade-off means being prepared to accept greater variability of income, but a higher overall yield than might be achieved otherwise. We’re certainly not prepared to over-pay for income just for the sake of it.”
COLUMBIA THREADNEEDLE INVESTMENTS
While others are turning their attention elsewhere, Jonathan Barber, portfolio manager of the Threadneedle UK Monthly Income Portfolio, believes UK equities still hold a wealth of opportunities for income-seekers.
“With the equity bull market now in its ninth year, it is easy to understand why there are concerns around markets getting overblown, but for portfolio managers focused on delivering a growing and sustainable income stream from UK equities, this market still offers opportunities as well as challenges,” he says.
“The fall in sterling, uncertainty around Brexit and heightened political risk have caused global asset allocators to be extremely underweight in UK equities. This has helped provide opportunities to invest in high-quality businesses with long-term prospects of dividend growth at attractive valuations.”
While valuations in some global markets look stretched, UK equities remain relatively attractively valued at around 14.5x 2017 earnings, broadly in line with their historic average.
Sterling weakness has delivered earnings upgrades for internationally-focused companies (75% of UK corporate earnings are generated overseas) and provided support for dividends, with dividend cover rising to around 1.75x.
“This is still below its historic average, but buttressed by strong company balance sheets,” he says. “The UK is on track to post record dividend payments this year, and not solely because of the weakness of the pound. Improving profits have also played their part as global economic growth has continued.
“We triangulate dividend yield with other valuation metrics to help assess when sentiment has obscured fundamental value. The current market backdrop is throwing up selective opportunities for discerning income investors to exploit.”