UK small- and mid-caps, commercial property and equity overwriting strategies are among some of the prime areas to hunt for income, according to Heartwood’s Jaisal Pastakia.
The investment manager says investors need to look beyond traditional, well-loved areas of the market if they want an income-paying portfolio given today’s low-yield environment.
He points out that many areas of the market are priced at a premium relative to their long-term averages, meaning many equity valuations look stretched and global government bond yields are sat at historic lows.
Performance of indices in 2016
Source: FE Analytics
“The search for income is being further complicated by an environment of low growth, low interest rates and low volatility,” Pastakia said. 
“Aside from investing in traditional higher yielding corporate bonds and emerging market debt, investors are looking towards niche sectors and more esoteric instruments as another approach to help deliver a steady income stream, without necessarily compromising on total return.”
In the below article, the investment manager (pictured) highlights four market areas he thinks are particularly attractive for generating income.
UK small- and mid-caps
A fall in the value of sterling and the subsequent rally of UK global-facing stocks means domestic-facing companies have been left behind somewhat recently.
Many investors have also been trimming their exposure to UK equities in the run-up to the triggering of Article 50, which is expected to happen in April next year as the country prepares to leave the European Union.
In an article published last week, FE Alpha Manager James Thomson, who runs Rathbone Global Opportunities, said he has reduced his UK regional weighting from 25 per cent to 15 per cent since the start of the year.
“I still think this will be a pretty strong headwind for the UK economy, even if it’s in areas where you don’t see it; where investment decisions would have been made but they’ve been further delayed before going somewhere else. It’s almost the absence of growth that may be a problem,” he explained.
However, Pastakia says certain areas of the UK market further down the cap spectrum are offering some interesting opportunities. While he says it is a challenging climate for small- and mid-caps at the moment and has therefore focused his exposure on US dollar earners, he is also buying into domestic market areas that look oversold.
Performance of indices in 2016
Source: FE Analytics
“Historically, these companies have shown appreciably more dividend cover than their large-cap counterparts and have also been able to grow those dividends at a faster rate,” he said.
“UK homebuilders, for example, have meaningfully underperformed the broader UK equity market over the last year, but the fundamentals remain sound. The UK continues to have a chronic shortage of housing and we expect demand to outstrip supply.”
Commercial property
The team at Heartwood says targeted commercial property exposures are also a good way to generate income.
This is an area of the market that has been hit by numerous headwinds over the course of 2016, with heightened valuations and the announcement of Brexit causing many investors to sell out of the asset class at once.
Performance of sector in 2016
Source: FE Analytics
As such, a number of fund houses including M&G, Standard Life and Columbia Threadneedle suspended dealings in their open-ended funds, although these have since reopened.
“UK commercial property has been beset by a number of headwinds this year, as a maturing investment cycle has endured the uncertainty created by the UK referendum result,” Pastakia said.
“While recognising these risks, we are maintaining a reasonable weighting in property but targeting exposures in specific areas: regions outside of London less affected by ‘Brexit’; industrial sites and warehouses; and smaller ‘lot sizes’.
“These markets have not experienced significant yield compression and investment activity remains resilient, despite the UK’s vote to leave the European Union.”
Lending strategies
Pastakia says traditional areas of the market such as government bonds and corporates now have a weaker backdrop given the pick-up in bond yields and focus on inflation.
But Heartwood has increased its investing horizon by holding market areas benefitting from bank retrenchment. In other words, it is investing in areas where lending would have historically been supplied by large commercial banks.
“Specialist private investors are now finding opportunities in niche lending strategies. In our portfolios, we have direct exposure to funding infrastructure projects and supplying loans to small- and medium-sized enterprises secured against assets,” he continued.
“These strategies offer a yield premium over higher yielding corporate bonds, often have lower default and recovery rates, and typically have a low correlation to equities and bonds. Indeed, as bond yields have risen over the past few weeks, the performance of direct lending strategies has been resilient.
“In addition, some of the underlying investments of these vehicles are floating rate notes, which provide a more defensive approach in an interest rate rising environment as coupons are reset periodically.”
Equity overwriting strategies
Options and overwriting strategies are favoured by many investors who are no longer seeing attractive opportunities in traditional equity markets.
Pastakia says they are a good way to both lower overall portfolio volatility and provide income for those looking to diversify their equity exposure.
“Equity overwriting strategies involve one investor selling to another the optionality to buy a stock at a fixed price above the current market price,” he explained.
“As equity markets have pushed higher, we have subsequently increased our exposure to this area of the marketplace for its ability to keep us invested (and not be forced into holding cash, which yields zero), deliver a steady income stream and lower portfolio volatility in times of market stress.”
Overall, the investment manager says buying into a wide range of more niche areas of the market is prudent when it comes to income generation.
He says the level of diversification it offers investors means it will help provide income without “overpromising” as it provides more levers.
“In our view, the key to a successful income strategy is to generate consistent and stable pay-outs over the long term without taking unnecessary risks,” he added.