Investors need to take care when looking for income opportunities, according to Janus Henderson’s David Smith, who said that the ‘hunt for yield’ has forced capital into riskier assets. 
With bond yields near all-time lows, many investors have moved up the risk scale, with more investing in equities as a source of income.
And Henderson High Income Trust manager Smith (pictured) said this is unlikely to change in the coming years, despite interest rates expected to rise and therefore bond yields expected to also improve.
“When you look at where bond yields are, they would have to move quite aggressively higher to look attractive relative to where equity income is at the moment,” he said. “The 10-year UK gilt yield is 1.2 per cent versus the UK equity market of 4 per cent.
“I think it does feel like interest rates are going to start moving higher – you have seen it from the Fed and the ECB are now talking about it – but actually I still feel pretty comfortable with equity yields at the moment because I do think that bonds are rising from a low level.
“If they move quickly it is a different matter but given that central banks around the world are probably still concerned about growth they won’t want to starve off growth in the short-term so won’t move interest rates up aggressively.”
While bond yields moving higher will provide a headwind to equity income trusts, the manager argued that they have to move significantly higher to be a substantial headwind.
“When you look at historical evidence, in a rising bond yield environment as long as you are below a 4 per cent bond yield, equities have performed well,” he said.
“As well, if you look at what is driving bond yields higher, whether its inflation or higher economic growth, those two environments are generally quite good equities.”
In addition, with more people coming into retirement – a figure that is expected to grow by 50 per cent in the next 20 years – the demand for income strategies is unlikely to diminish.
For investors happy to take on this additional risk that comes with equities, investing in income trusts can prove fruitful, he argued.
“If you look at income strategies over the longer term and not just in the last eight or nine as interest rates have fallen to historic lows, they generally outperform all other strategies because the dividend yield plus the dividend growth are the main contributors to total returns in the long-term,” the manager said.
Performance of sector vs benchmark over 20yrs
Source: FE Analytics
As the above shows, the IT UK Equity Income sector has outperformed the FTSE All Share by 58.6 percentage points over 20 years.
However, investors need to remain vigilant in their analysis of equity income opportunities, with the below chart showing that forecast higher headline yields do not necessarily mean that they will provide a realise yield.
“[In this chart] the grey bars represent what your forecast yield was and the red bars show you what you actually earned in terms of the dividend at various different levels of dividend yield,” Smith said.
“As you can see the higher the dividend yield the less likely you are to actually earn that dividend and that is because the dividend yield in isolation can be a misleading guide to value.
“It is actually more important that the company not only sustains their dividend but also grows it in the longer term.”
This is because the market generally starts to discount dividend cuts, he noted, with a recent example in the oil & gas sector.
Many of the oil majors now offer attractive headline yields of up to 7 per cent but there is much debate in the market about whether those dividends are sustainable at current oil price.
“It is the way the market is asking to be rewarded for that extra risk they are taking over the sustainability of the dividend,” the manager said.
However, if a company cannot pay its dividend, the headline yield is irrelevant. This was the case with supermarket chain Tesco, which saw its headline yield rise to 10 per cent.
“The reason it was 10 per cent was because they couldn’t pay the dividend and they cut it,” he explained. “So actually that was yield illusion, it wasn’t yielding 10 per cent because it then got to cut to zero.
“Hence, the market was asking to be paid this huge premium to take on the risk of the dividend and in the end it wasn’t worth it because it got cut.
“I always find that the dividend yield is a good way of looking at valuations. A low dividend yield for an income fund manager means you can’t go near it but a high one, yes, it looks attractive, but you have to be very disciplined in analysing the underlying company and the health of the cashflows to see if the dividend is sustainable,” said Smith.
“That doesn’t mean to say that companies with dividend yields higher than that 6 per cent level can’t sustain their dividends and sometimes you find the best performing stocks are the ones that are yielding high dividend yields but they sustain it and you get a huge re-rating on the back of that.”
As such, the manager invests in a range of high to lower yielding stocks in an effort to offer attractive income opportunities with a lower risk.
“If we are the lower end of that range then we will expect more in terms of dividend growth and if we are the higher end of the range then we would expect a little bit less in terms of dividend growth going forward,” he said.
At the lower end, the manager owns accounting software provider Sage Group, which is currently offering a 2.83 per cent dividend.
“It is a pretty stable business with 75 per cent of the business subscription-based and a 95 per cent renewal basis,” the manager noted.
“When you look at the valuation it has come back a bit and the yield has come down a bit so it is around a 2.83 per cent dividend yield but we expect that to grow in the high single digits.
“You can still make a credible case where you can make a total return just from your dividend yield and from dividend growth of around 13 per cent without any re-rating and actually that is pretty secure going forward.”
Performance of stocks over 5yrs
Source: FE Analytics
In comparison, he also owns Phoenix Group, a specialist in closed life insurance company acquisitions, which is currently yielding 7.5 per cent.
“They have just made a number of acquisitions including AXA Life and Abbey Life and, given their core competency of being a closed life consolidator, they have got the expertise to drive synergies and better cashflows out of those acquisitions,” Smith said.
“Given that they have delivered in the past and these acquisitions were made in the last 18 months actually that sustains your cashflow payments from the business certainly out to the next 10 years.
“I am reasonably secure that you will get that 7.5 per cent dividend in the medium-to-longer term and that is where I am happy to buy those higher level payers above the 6 per cent range.”