With the population getting older and the pension system set for big changes following last year’s Budget, income investing is all anyone is talking about at the moment.
On top of that, interest rates are at ultra-low levels and savers are receiving a scarce amount for holding their hard earned cash in the bank – making a stable income stream all the more important.
Investors are increasingly looking towards assets which pay out an income to help them through either their working life or during retirement, but how much do those investors really know about these investments?
In this article, FE Trustnet walks through the different yielding assets and assesses their pros and cons.
Bonds have been the go-to security for income seeking investors over the years, especially for those who don’t want to take too much risk within their portfolio.
The pros are clear as, unless the government or company they have lent to defaults, investors receive their money back in full at the maturity of the bond and in the meantime earn income.
The cons, on the other hand, revolve around the fact that the amount of income they receive won’t grow in line with inflation as it is fixed.
On top of that, they are expensive relative to their history – concerns about the global economy after the financial crisis in 2008 have pushed bond yields down to very low levels as investors have scrambled for safer assets.
Performance of sector and indices since January 2008
Source: FE Analytics
Investors can of course find bonds with higher yields by lending to corporates or governments with a lower credit rating, but there is an increased chance of default.
Ben Willis, head of research at Whitechurch, says investors should be wary of relying on bonds too heavily within their portfolio. Though the income they receive won’t fall, as fixed income assets are expensive and as interest rates are expected to rise, the value of their bond is likely to drop over time.
Given those concerns, many investors have made the shift to equities for their income.
Earning income from a company’s dividend is an attractive option because the amount an investor receives can grow over time and is therefore seen as a good hedge against inflation. Dividends can be cut, of course, like with banks in 2008 and BP after its oil spill in 2010.
Performance of stock versus index in 2010
Source: FE Analytics
Equities are also generally far more volatile than bonds, which means they are not always suited to risk-averse investors.
One major mistake investors make is the belief that a dividend yield accurately reflects the amount of income they will receive which – as FE Trustnet has shown on a number of occasions – isn’t the case.
That is because yield is the dividend per share divided by the share price, so if the yield has risen it could just mean that the share price has fallen. Also, if a stock has a high yield, it can often suggest that the wider market doesn’t think the company will be able to pay that dividend.
Therefore, Iain Cunningham, co-manager on the Schroder Global Multi-Asset Income fund, says income investors should focus on higher quality companies that are more likely to maintain their dividends, whilst paying close attention to valuations.
“One of the biggest risks in investing is the risk of permanent capital loss which can be mitigated by analysing a security issuer’s future ability to pay dividends or meet coupon and principal payments,” Cunningham said.
“We believe it is imperative to focus on investing in high quality securities which are able to sustain, and in the case of equities, grow their income streams. This should minimise the risk of capital loss, while not sacrificing quality for yield or paying any price for quality.”
Nevertheless, though both bonds and equities have their pros and cons investors have been able to build a decent income-paying portfolio over the years by combining the two asset classes.
However, Rob Morgan (pictured), pensions and investment analyst at Charles Stanley Direct, says this more traditional asset allocation is unlikely to continue to be so successful.
“I am actually quite worried about the consequences of an inflation shock sometime in the future and how asset prices would react,” Morgan said.
“Conventional bonds and many equities could both sell off. Having other assets such as property, commodities, inflation-linked bonds and perhaps some absolute return strategies could help and in most of these areas you can generate income too.”
Obviously, investors can build their own diversified portfolios of different income paying assets themselves, combining bonds, equities, property, infrastructure, asset backed securities etc. However, an easier option could be to choose a core multi-asset income fund to act as a ‘one stop shop’.
There are various funds within the IA Mixed Investment 0%-35%, Mixed Investment 20%-60%, Mixed Investment 40%-85% and Flexible Investment sectors that can give you that sort of core income exposure.
A key part to check, however, is how often they pay out to investors as some have a dividend frequency of just twice a year, while others distribute every month.
No matter how regular the dividend is, Cunningham says that genuine income seeking investors need to focus on funds which offer active risk management and diversification.
To illustrate, if an investor is drawing income from, say, a £100,000 pot and that pot falls in value by 25 per cent, they will only be drawing income from £75,000. It’s easy to see the income will be materially lower than before.
Cunningham added: “Managing risk is key to minimising drawdowns. We manage the risks from unrewarded betas within the fund including the flexibility to hedge duration and equity market risk.”
This article was written in collaboration with and is sponsored by Schroders.