The income versus total return challenge
Marcus Brooks explains why it is important to take a step back and think about the total return, not just the income.
Income generated from an investment is often a significant part of the overall return, and many investors elect to receive the income generated by their portfolios to use for their own purposes.
Traditionally fixed income or bond investments have provided a stable and predictable source of income, and have formed a significant part of portfolios requiring income generation. However, the long period of very low interest rates following the 2008/9 recession, together with quantitative easing, whereby central banks have been buying bonds so as to depress longer term interest rates, means that income yields on many investment grade corporate bonds are very low. Yields on some government debt are lower still and in some cases, actually negative (investors are paying to lend money to some governments). With inflation remaining low and global economic growth anaemic, these conditions are likely to persist. Lower quality corporate debt does continue to pay out a reasonable level of income but we would not wish to be too committed to this asset class because it is economically sensitive.
More generally, income yields on a wide variety of assets are trading at historically low levels. If investors do require to take an ‘income’ from their portfolio, one solution may be to consider matters in terms of total return – capital and income combined. The investor decides on the level of withdrawal from the portfolio that is required and allows the manager to meet that requirement from a combination of capital realisation and income generation. A rough rule of thumb, derived from historic total return statistics on a variety of asset classes, suggests a portfolio can accommodate an annual drawdown of between 3% and 4%, while allowing capital value to keep up with inflation over the medium to long term.
A total return approach does have the advantage of allowing the manager flexibility to pursue investment returns from the best sources available without any focus on whether this is from capital growth or income generation.However, some investors are unable to draw down on capital and others wish to keep capital growth and income separate and, if a reasonable level of income is required, portfolios need to be structured to generate this. In the current environment this can prove challenging but not impossible. The first thing to say is that a very high yield can be an indicator of financial distress (in a company share price or bond) and may indicate risk to that income in the future. Having said this, many well financed growing UK companies are paying out attractive levels of dividend at present, and these can be expected to grow in real terms over time. In recent years, yields in other global equity markets have risen significantly especially in Europe, the Far East and Emerging Markets.
Beyond this, there are a number of niche opportunities available to generate higher yields. These ‘real’ assets, which have visible income streams, often have a degree of government backing and we hold a number in client portfolios. These are typically structured as investment trusts, so are traded on the London Stock Exchange, and include specialist healthcare real estate (Assura), infrastructure debt (GCP Infrastructure Income, Sequoia Economic Infrastructure Income), and infrastructure equity (HICL Infrastructure, International Public Partnerships). While offering attractive dividend yields of 4-6%, these investments do have additional risks that need to be understood, particularly since many have moved to premiums to asset value in part driven by investors need for yield.
In this low yield environment our experienced Investment Managers will consider and discuss with Clients the merits of the total return approach and where this may not possible ensure that sources of income are well diversified.