Hunting for yield has been one of the toughest things to do in recent years with lower bond yields and interest rates drastically shifting the income-opportunities available.
With yields at record lows, FE Trustnet asks the experts what they see as a reasonable level of expected yield from fixed income and equities.
Darius McDermott managing director of Chelsea Financial Services, said: “Since the global financial crisis, investors been slowly but surely pushed further and further up the risk scale to find a decent level of income. Rising inflation is now exacerbating the situation.
“The days of 5 per cent interest rates on cash are long gone and expectations of income levels do need to be revised somewhat. There aren't many investments yielding 5+ per cent today and those there are, are considerably more risky than cash.
“Very few cash accounts are higher than inflation now, which means savings are being gently eroded in real terms.”
CPI inflation projection
Source: Bank of England
“If inflation reaches 3 per cent and interest rates don't rise, £100 could be the equivalent of just £93.26 in three years’ time. If it gets as high as 4 per cent then the buying power of the £100 falls to £88.47,” McDermott said.
Architas investment director Adrian Lowcock added: “The yield available on some funds might surprise investors as the theme for the last few years has been the hunt for income.”
Below, we look at the available yields in the UK equities and in fixed income spaces to see what a reasonable level of expected yield is.
UK equities
Equities have been on a strong run over the last few years in particular the high dividend payers as bond prices have continued to rise, forcing investors into the riskier asset class.
The area of the market many have turned to is the ‘bond proxies’ – equities paying yields higher than those on offer in the bond market – also known as the ‘expensive defensives’.
McDermott said: “Bond proxies have become expensive and specialist asset classes like infrastructure, where many vehicles are investment trusts, have seen demand push up premiums to very high levels.”
Performance of index over 5yrs
Source: FE Analytics
Yet, Architas’ Lowcock says equity income has continued to offer attractive yields as companies are able to grow their profits and their yields.
“It is not all rosy though as last year we saw many companies pay dividends which were not fully funded from current earnings, instead companies either borrowed (at low rates) or paid dividends from retained earnings from previous years,” he said.
“The issue is that some dividend paying companies are better quality than others. Investors seeking income want some security over future dividends as a cut downline will not all mean they see a drop in their income but also a likely fall in the value of the shares.”
The average yield for the IA UK Equity Income sector is around 4 per cent, and this is a level that Simon Evan-Cook, senior investment manager at Premier Asset Management says investors should be looking to achieve.
“Across the different asset classes, we think 4 per cent is achievable from a UK equity income fund without taking undue risk, although this figure is closer to 3 per cent if the manager is more focused on growing the income stream, rather than simply paying out a high income today,” he said.
However, Lowcock adds that investors should be careful of averages as in the UK Equity income sector includes a few funds which have enhanced income characteristics.
“They basically look to exchange capital growth for income,” he said, pointing to Schroder Maximiser Income, which has a yield of more than 7 per cent, as an example of this.
“Investors need to weigh up the options a lower yield in the short term might be better if the yield is set to grow at a much faster rate, whilst an investor in need of income immediately might be more willing to sacrifice the dividend.”
Rob Burdett, co-head of multi-manager solutions at BMO Global Asset Management, says he is most comfortable taking income from equities. 
“You’ve got even on an average basis a yield that is materially above cash, materially above inflation and it will grow this year maybe not the headline index level but it will at the average equity income fund manager level,” Burdett (pictured) said.
“And those [managers] that we’re talking to are talking about at least 5 per cent growth on last year’s dividends so that’s fantastic. I think the average yield is attractive and you can get more than that and it will grow so that’s good news.”
Bonds
Moving to fixed income, McDermott says inflation remains the biggest detractor for investors, as it erodes the real return you receive.
He explained: “Finding a bond fund with a higher yield to compensate for higher inflation will be key. The trouble is, the higher the yield, usually the higher the risk.”
Premier’s Evan-Cook added: “In the bond world, high-yield corporate bonds should be getting close to 5 per cent without stretching too far, with maybe 4 per cent realistic for an income-focused strategic bond fund, and 3.5 per cent for an investment-grade fund.”
Looking at the high yield sector, Architas’ Lowcock said: “The average yield in this sector is just over 5 per cent, which is an indication of the compression in yields we have seen in recent years. Historically this sector would have provided a higher yield.
“Investors need really weigh up risk and return in this asset class. Here the higher yield is usually a good sign of a much higher risk.”
Despite the higher returns on offer, the higher risks means BMO’s Burdett currently does not include any pure high yield funds in its portfolios.
“Arguments in favour of high yield tend to be that whereas in the past very few people could issue bonds with more than a five-year term the era of ultra-low rates has left people desperate for yield so borrowers have been able to have much longer duration high yield,” he said.
“So maybe they’re not having to repay the capital for longer and therefore they’ve less likely to go bust but essentially they will have to repay it and if the market yield is much higher then that could be quite painful.
“We don’t have any pure high yield funds either at the moment because although the yield might seem attractive at 4.93 per cent and again the spread might look okay we are still referencing ultra-low rates and that’s leading on to rising inflation.
He also doesn’t own any investment grade funds, which has an average of 2.92 per cent – far lower than the investment grade and equity returns.
“That is not far off inflation and obviously you’ve got credit risk and that is close to a record low yield,” he said.
“There may be an argument that it is not a record low spread to government bonds but obviously you are at an extreme, experimental level of interest rates at the moment and really from here the only way is up – the only question is when and how much.
“That introduces duration risks to gilts and investment grade corporate bonds as well so you can see at least on a measured basis a significant fall in capital. You’re not being paid much yield and you have credit risk as well as duration risk so for that reason we don’t own a single conventional investment grade corporate bond fund.”
Performance of index over 5yrs
Source: FE Analytics
The area he has invested in is strategic bonds, though this has been the worst performing sector of the three over the past five years.
“The actual average is only 3.42 per cent and I guess you would expect it to be somewhere between high yield and investment grade because in theory that is the high and low of their universe,” Burdett said.
“They can use government bonds, inflation-linked and all sorts and not all do and whenever we look at a strategic bond we look at the breadth of brief the fund manager is given and crucially whether they use the full breadth of that brief.”
Architas’ Lowcock added: “This sector has been popular with investors as it means they can delegate the entire asset allocation decision on where to invest in the bond market and when to make those changes.
“This type of fund gives the manager a significant amount of flexibility as they can invest in gilts to high yield. This flexibility also means that you get a broad range of funds in the sector with differing objectives.”
In an upcoming series, FE Trustnet will look at the funds these market commentators are focusing on in both the fixed income and UK equity sectors.