The obvious starting point had always been bonds, or lending your money to a government or company and receiving a fixed level of income on a regular basis until the product matures, at which point you are given back your initial investment.
However, due to a number of unprecedented factors such as quantitative easing and previous mass inflows into the asset class, yields on government and corporate bonds are now at ultra-low levels and the general feeling is that they can only go up.
The problem is that if interest rates were to rise – the Bank of England’s base rate is at a record low of 0.5 per cent – bond managers with long-duration debt could be stuck with overvalued assets that they could only sell at severely reduced prices.
These headwinds have meant that investors are now looking for more risky areas of the market for income, but are they paying over the odds for the chance to get a higher yield?
Assessing the price of individual defensive dividend-paying stocks is beyond the reach of most private investors, but for those who use investment trusts for their equity exposure, they will have noticed a broad theme developing.
Most trusts that offer some form of income are now trading on a much tighter discount to their previous average – meaning investors are paying close to the actual value of the assets in the portfolio. Most of the time, investors are paying a premium for such levels of yield.
Out of a possible 21 closed-ended funds in the IT UK Growth & Income sector, 14 of them are trading on a premium to their NAV. Eleven of those 21 funds are now more expensive than their one-year average and 13 of them are more expensive than their three-year average.
It is a similar story outside of the UK.
Take Bruce Stout’s Murray International trust. Obviously, it is understandable why the trust has attracted high levels of investor attention in the first place.
It is the best-performing portfolio in the IT Global Growth & Income sector over five years, with returns of 119.56 per cent, comfortably beating its composite benchmark – split 60/40 between the FTSE World ex UK and FTSE World UK indices.
Performance of trust vs benchmark over 5yrs
Source: FE Analytics
The trust also has a headline yield of 3.49 per cent and our data shows it has consistently upped its net distribution over recent years. However, at a premium of 11.41 per cent, investors are now really paying up for income and Stout’s expertise.
Areas of the closed-ended market such as infrastructure and property are also back in vogue.
This is because of their income potential. Investment trusts tend to have an advantage when it comes to property, because they do not have to worry about mass outflows if things go belly-up.
Commercial property is also a steady income play because the rents available from the asset class are not only higher than gilt yields but also allow for a degree of inflation protection.
Every trust in the IT Infrastructure sector has a headline yield of above 4.5 per cent. However, they are also all trading on close to a 10 per cent premium and all of them are now more expensive than their average price over the last year.
There are differing points of view from industry experts on this matter.
Peter Walls, manager of the Unicorn Mastertrust, says he finds it uncomfortable to ever buy a trust on a premium because he feels the only surprise you can get is on the downside.
On the other hand, Jupiter’s Richard Curling says he is changing his strategy and is now just focusing on the best-possible managers instead of wasting time trying to find cheaper – and possibly lower-quality – alternatives.
Charles Cade (pictured), head of research at Numis Securities, understands that private investors do need a healthy level of income but urges them to understand the risks involved when buying a trust on a premium to its NAV. "I think that investors should identify trusts from a total return basis. But if you are paying a premium for a trust with a high yield, then the risk is that that total return might come off," he said.
Despite his concerns about the premiums on the majority of income trusts, he says this trend could continue as it is a simple supply/demand dynamic.
"I think that in the near-term, yield will remain popular as long as interest rates remain low. However, investors need to be aware of valuations and shouldn’t let them get to extreme levels," he added.
Cade points out that a change in investor sentiment is not the only catalyst that can cause a discount to widen. He points out that management teams can make the shareholder base bigger by issuing more shares to rein in a trust’s premium.
He highlights two trusts that offer investors an attractive yield and are still relatively cheap compared with other income-generating portfolios.
JP Morgan European IT Income
JP Morgan European IT Income offers investors a yield of 4.07 per cent and is trading on an 11.54 per cent discount to its NAV, which is roughly in line with both its one-year and three-year discount.
The trust – which is headed-up by the trio of Stephen Macklow-Smith, Alexander Fitzalan Howard and Michael Barakos – has returned 61.87 per cent over five years while its MSCI Europe benchmark has returned 38.62 per cent.
Performance of trust vs index over 5yrs
Source: FE Analytics
Investors may well be cautious of investing in a European portfolio given the macroeconomic uncertainties. However, the trust tends to focus on larger caps, with European blue chips such as Novartis, Roche and BNP Paribas all in its top-10 holdings.
The trust has gearing of 12 per cent and has ongoing charges of 1.14 per cent, though it does have a performance fee.
Aberforth Geared Income
Again, this trust is a more risky investment than other income-producing portfolios, but Cade says Aberforth Geared Income’s 47 per cent gearing is how it generates its 4.7 per cent yield. The trust is trading on a 13 per cent discount to its NAV.
Aberforth Geared Income was launched in April 2010 and over that time it has returned 57.71 per cent. It had underperformed between the summers of 2011 and 2012, but it has bounced back and over one year has returned an impressive 55.24 per cent.
The managers have a value style and run a portfolio of 77 holdings. The trust’s largest individual holding is RPC – the packaging company – but it also holds other well-known smaller companies such as Galliford Try and Tullet Prebon in its top-10.
Aberforth Geared Income has an annual management charge of 1 per cent.
