When you’re running a household on payouts from your investment portfolios, both the level of income and its reliability are likely to be uppermost in your mind.
Indeed, the more your budget revolves around investment income (as opposed to other sources such as state pension or a final salary pension), the more important that reliability becomes.
So, what investment strategies could you consider to minimise the risk of income volatility?
Investment trust strengths
Investment trusts are a natural first port of call for income seekers, as – unlike open-ended funds – they can retain up to 15% of the earnings from their underlying holdings each year and build reserves. Trusts can use these to supplement payouts to shareholders in leaner years, when earnings are on the low side.
As a consequence, certain trusts have built a strong reputation for year-on-year dividend increases (or at least no cuts) over many decades, as highlighted by the Association of Investment Companies’ (AIC) annual Dividend Heroes table.
Importantly, not all the dividend heroes actually have a strong income focus, but among them are a number of income-oriented trusts whose dividend-raising reputation is now so well-established and valuable that they would go to considerable lengths to protect it.
These include the likes of City of London Ord (LSE:CTY), JPMorgan Claverhouse Ord (LSE:JCH), Murray Income Trust Ord (LSE:MUT) and Merchants Trust Ord (LSE:MRCH), all UK equity income trusts currently yielding 4%-plus.
A number of trusts focused on both income and growth have also adopted “enhanced dividend” mandates to pay out a set percentage (often 4%) of the trust’s net asset value (NAV) on a specific date, among them JPMorgan Global Growth & Income Ord (LSE:JGGI), Montanaro UK Smaller Companies Ord (LSE:MTU) and Polar Capital Global Financials Ord (LSE:PCFT).
Of course, NAV will fluctuate from year to year, but over the longer term it tends to rise, and therefore so will the dividend paid out. Again, that provides income-seeking shareholders with both reasonable security and a measure of inflation protection over time.
Geographical diversification
Historically, the UK has been the richest source of dividend-paying companies, and there are many respected trusts with a UK mandate. However, income seekers would be missing a trick to limit themselves exclusively to UK equity income trusts.
Not only are there great opportunities to be had further afield, but by broadening coverage and reducing dependence on the fortunes of a single economy, investors help to strengthen their overall portfolio.
The obvious challenger in terms of dividend popularity and growth is Asia Pacific, which has established itself as a leading dividend-paying region.
In a discussion at the AIC’s recent Investment Trust Showcase event, Richard Sennitt, manager of Schroder Oriental Income Ord (LSE:SOI) investment trust, pointed out that of all the stocks yielding more than 4% globally, around 40% come from Asia.
That means income-focused managers of Asia funds are spoilt for choice and certainly don’t have to buy particular stocks simply because they offer a good yield.
At the same session, Isaac Thong, manager of the Aberdeen Asian Income Fund Limited (LSE:AAIF) fund, estimated that there are twice as many income stocks for managers to choose from in Asia as in the UK.
Sennitt made the additional point that on a total return basis, Asia more than holds its own: “Average yields there are slightly lower than from the UK, but you’re also getting exposure to a high-growth area.”
In terms of diversification, too, it makes a lot of sense from a risk-adjusted perspective for income investors to hold Asian assets as well as UK ones. “Compositionally, the market is quite different from that of the UK, with a big IT sector and a real dispersion of geographies,” said Sennitt.
Moreover, as Sat Duhra, manager of Henderson Far East Income Ord (LSE:HFEL), observed, there is continuing pressure for corporate reform from Asian governments and authorities, and that is helping to drive increasing yields as companies pay greater attention to shareholder interests.
It remains true that issues such as global geopolitics and the export-oriented nature of many Asian markets makes them inherently more volatile than the UK. Additionally, Asia has a long reputation for so-called value traps – dysfunctional businesses with low valuations and high yields.
But the managers speaking at the AIC conference all emphasised the importance of a bottom-up approach, identifying high-quality businesses with resilient business models and strong free cash-flow that are hitting an optimal balance between capital reinvestment and capital returns.
Beyond equities
While diversifying into Asia can provide an attractive combination of growth and income, the use of bond-focused investment trusts for high, sustainable yields and relatively low volatility is a further opportunity to fortify your portfolio.
The use of investment trusts by retail investors for access to corporate bonds and public debt has grown significantly in recent years, and indeed the AIC Debt – Loans & Bonds sector currently trades on a small premium as demand exceeds the market supply.
Why are bonds so popular at the moment?
“Equity markets are at or near all-time highs, but there is a lot of macroeconomic uncertainty out there,” explained Pieter Staelens of CVC Income & Growth GBP (LSE:CVCG) during a discussion of high-income trusts at the AIC event. “We are seeing investors taking some risk off the table and parking cash in stable, income-producing alternatives.”
Moreover, fixed-income fund payouts are currently generous in historic terms – the sector averages an attractive 8% yield, reflecting the higher interest rate environment of recent years.
Yet the sector is delivering these strong returns for notably less risk than in the past. George Curtis, manager of TwentyFour Select Monthly Income Ord (LSE:SMIF) trust – a diversified portfolio of credit currently paying an 8.5% yield – put that into perspective.
“In 2021 you’d have needed a CCC-rated [relatively high-risk corporate bond] portfolio to get the kind of returns that you can get from a much higher-rated portfolio now. We have the highest-rated portfolio we’ve ever had, but our average yield is 2% more than in 2021.”
Different managers reduce volatility through various means, including broad diversification across the spectrum, investing mainly in higher-grade bonds, and using floating-rate assets that pay variable yields in line with interest rates (and therefore are not disadvantaged if rates go up).
Ultimately, as Staelens pointed out: “There will be some volatility in the value of the underlying assets when investor demand reduces and credit spreads widen – but these businesses just pay their coupon every quarter and the income keeps on coming regardless.”
Infrastructure benefits
For further robustness, it’s worth considering exposure to alternative assets such as infrastructure, which focus heavily on the provision of a generous income plus capital preservation.
Infrastructure trusts invest in big projects involving long-term, often government-backed, contracts. In return they receive steady cash flows – including a significant and reliable chunk from various government subsidy mechanisms, typically with an element of inflation linkage – that enable them to pay generous and rising dividends. The AIC Infrastructure sector average is currently 6%, although this covers a broad spread of yields.
With the whole sector on a discount averaging 15% despite its inherent attractions for income investors (predictable, long-dated cash flows, inflation protection, low correlation to other assets, little sensitivity to economic growth trends), Philip Kent, manager of GCP Infrastructure Investment Ord (LSE:GCP) believes the current time is a good opportunity to buy into the asset class.
He highlights the fact that the government’s recently published 10-year infrastructure strategy commits to £725 billion funding for social and economic infrastructure over the next decade, while more than £500 billion of private sector investment has been agreed.
“Now is the time when there is lots of opportunity in UK infrastructure, and government support is aligning to enhance that,” Kent concludes.
Capital preservation
Many income investors are keen to prioritise capital protection as well as a decent income. Investment trusts such as STS Global Income & Growth Trust Ord (LSE:STS), currently yielding 3.5%, are designed to do just that job.
“In times of plenty, focusing on limiting losses and producing a steady, growing stream of income are attributes rarely valued by investors,” observes manager James Harries. “But equity markets, driven by a very narrow group of companies associated with the AI infrastructure buildout, face a triple vulnerability,”
He points out that if the AI boom that has been bolstering both economies and markets falters, it could mean a wider hit, hurting other sectors currently prospering, such as banking and mining, “which are cyclical, capital-intensive, and, in the case of banks, highly levered”.
Harries aims to avoid such businesses and focuses instead on sectors and companies that are predictable, well-financed and enjoy sustainable competitive advantages.
“There are good reasons why income has been a focus for a particular cohort of investors for centuries, and if we are in for a more challenging time, these attributes may well become highly prized once again,” he says.
So, income investors have a strengthening armoury of investment opportunities from which to choose. Once again, diversification across several asset classes should help keep capital safe and income reliable.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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