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The equity income funds to buy if bond yields rise

04 June 2015

Industry experts tell FE Trustnet which equity income funds they think will do best if bonds yields were to rise substantially.

By Alex Paget,

Senior Reporter, FE Trustnet

One of the major concerns with industry experts in the current environment is the outlook for fixed income – especially given the recent rout in the sovereign debt market which caused some of the safest financial assets such as UK gilts, US treasuries and German bunds to fall sharply in value.

Performance of indices in 2015

 

Source: FE Analytics

Many have warned that bond yields will continue to rise significantly over the short to medium term as economic growth continues to strengthen, inflation picks up and central bankers start tightening monetary policy by raising interest rates.

While bonds and equities have historically been negatively correlated, that trend has reversed substantially recently due to the distorting effect of quantitative easing and as a result several market commentators have argued that large-cap equity income funds will also struggle when bond prices fall.

Of course, the jury is still very much out on whether interest rates will rise given recent lacklustre GDP figures out of the US and UK. Also, the reality is that equity income is going to remain popular as a result of the ageing population and the recent changes to the pensions system.

Nevertheless, if investors are worried about the implication of a bond market correction on equity income funds Hawksmoor’s Richard Scott says there are certain areas of the market they should focus on more than others.

“In particular, the areas you want to avoid if you think bond yields are going to rise are stocks which have become known as bond proxies. These are companies that have relatively high yields but offer very little growth,” Scott (pictured) said.

Sectors which fall into the category of bond proxies include the likes of consumer staples, utilities and, to a lesser extent, pharmaceuticals as due to the reliable nature of their earnings their dividends are viewed as being extremely safe.

Some of the best known equity income funds that have high exposure to those parts of the market include Michael Clark’s £1bn Fidelity Moneybuilder Dividend, which has a big overweight in utilities, and Nick Train’s Finsbury Growth & Income trust, which has 23.1 per cent in consumer staples Unilever, Diageo and Heineken.

Another example is the highly-popular CF Woodford Equity Income fund, which has 13.57 per cent in pharmaceuticals GlaxoSmithKline and AstraZeneca as well as 15.4 per cent in tobacco stocks Imperial Tobacco, British American Tobacco and Reynolds American.

Scott says investors need to focus on funds which have a different approach to equity income.

“Certainly, when you look at the type of equity income funds we own they are run by managers who are focused on dividend growth over and above dividend yield,” Scott said.

“The ability of companies to grow their dividends and deliver dividend growth will set them apart from the danger of de-rating when bond yields and interest rates rise.”

One which he thinks fits this category perfectly is Dan RobertsFidelity Global Dividend fund.

The £170m fund, which only launched in January 2012, does pay attention to dividend yields but Roberts is more focused on finding a growing source of income. That is why Scott isn’t overly concerned that Fidelity Global Dividend’s yield is just 2.82 per cent.


 

According to FE Analytics, the Fidelity fund has been the third best performing portfolio in the IA Global Equity Income sector since launch with returns of 58.60 per cent and has beaten its MSCI AC World Index by 6 percentage points in the process.

Performance of fund versus sector and index since Jan 2012

 

Source: FE Analytics  

FE data shows it has also increased its distribution in each year since launch, paying out £390.62 on £10,000 in 2013 and £447.43 on £10,000 as of its latest 2015 dividend payment.

Russ Koesterich, BlackRock’s global chief investment strategist, echoes Scott’s views on equity income funds.

“Investors should also look to broaden their search for income beyond bonds. This suggests a greater emphasis on dividend-paying stocks, with an important caveat: focus on dividend growth rather than the absolute level of yield,” Koesterich said.

“Many sectors offering high yields (such as utilities) are expensive and the most vulnerable to a rise in rates. Instead, yield-hungry investors should look for technology, financials, health care and select energy companies offering rising dividends.

Though it isn’t known for its dividends, the IA UK Equity Income funds with the highest weighting to the tech sector are Evenlode Income (10 per cent), Jupiter Income (8.42 per cent) and Newton UK Income (6.72 per cent).

Financials are more widely held and that is shown by the popularity of the insurance sector within the peer group. Banks have fallen off most income investors radars but many are expected to make up a much larger proportion of the dividend paying market than they are currently.

Old Mutual UK Equity Income has the highest exposure to financials in the sector at more than 40 per cent, as manager Stephen Message counts the likes of Aviva, HSBC, Barclays, ICAP and Lloyds as top 10 holdings.

Apart from focusing on dividend growth Ben Conway, who works alongside Richard Scott on the Hawksmoor fund of funds range, says investors should focus on benchmark agnostic managers if they are concerned about rising bond yields.

“The major point is that equity income as a style has done extremely well and we have long been exposed to it in our funds. We are wary about the general level of valuations across equity markets and so we want our managers to have the greatest amount of flexibility,” Conway said.

“We don’t want our managers to be restricted by size because as soon as they are, they can only be exposed to a certain area of the market.”

“One of the funds we favour [Standard Life Investments UK Equity Income Unconstrained] is still relatively small and the manager has a huge amount of flexibility. That manager also happens to be extremely bottom-up and very valuation centric and doesn’t like to take an awful lot of earnings risk.”

He added: “One would hope there is some margin of safety despite elevated equity valuations.”

Thomas Moore is quickly becoming one of the highest rated managers in the UK equity space due to his work as manager on the five crown-rated Standard Life Investments UK Equity Income Unconstrained fund.

The manager, like Dan Roberts at Fidelity, focuses on dividend growth over headline yield and also invests across the UK market for opportunities.

This means his £878m fund has been the fourth best performing portfolio in the IA UK Equity Income sector since he took charge in January 2009 with returns of 220.47 per cent. As a point of comparison, the FTSE All Share has gained 114.59 per cent over that time.

Performance of fund versus sector and index since Jan 2009

 

Source: FE Analytics


 

Like with Fidelity Global Dividend, FE data shows Moore has increased his dividend in every year since he has been at the helm. Investors who bought £10,000 of units in 2009 would have earned £540 in income in that year; this would have grown to more than £1,000 in the last full calendar year.

 

Source: FE Analytics

Conway says there is another type of equity income fund investors should focus on at the moment, though. 

“The other thing I would say about our equity income exposure is some of our largest holdings are in funds that the ability to overwrite call options,” he said.

Conway and Scott’s two largest holdings in their distribution funds are Fidelity Enhanced Income and RWC Enhanced Income, which boost income by using call options.

Call options create a ceiling over potential returns in strongly rising markets, but given that they are receiving a higher level of income, funds that use them can protect investors more effectively when the market falls.

Conway says this is important in the current market as given that asset classes are now tightly correlated, equities are also likely to fall in the event of a bond market sell-off.  

“Because of the overall falling levels of yield available from equities, it’s becoming more and more difficult to generate a satisfactory level of income for investors,” Conway said.

“When you have the view, like we do, that the amount of upside left in equities is diminishing by the day, if you can hold a fund that can generate income by writing calls – which means that if equity markets rose too fast too quickly it wouldn’t participate because it would be sacrificing upside for the income – that is the type of fund we are happy to be exposed to.” 

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