Investors face a challenge and a dilemma in the wake of steep cuts in interest rates as they seek to generate income.
There are many ways to generate income. The approach depends on the type of income sought and frequency of payments required. The underlying condition of the markets also plays a role. If building an income over time, it is sensible to invest in a way that introduces the prospect of capital appreciation, such as the stockmarket, to encourage that income to rise over the long term. If investors want a high and/or immediate income, a higher allocation to income-producing assets such as bonds might be wise, but that may come at the cost of capital growth.
As a general rule, the more income investors expect to receive, the less reliable the sources of this will be and the greater potential risk to capital. There are many assets capable of generating income, such as bonds (through coupons on the loans), equities (through dividends) and property (through rental yield). The key thing is to understand the risks of each, what factors affect the income stream and how it is likely to vary through a typical economic cycle. In general, equities “lead”, which means they suffer investor redemptions ahead of an economic downturn, while property “lags”, which means that capital values suffer as a result of an economic cycle.
Whatever type of income is being sought, stability is key. To achieve a stable income, it is important to watch capital values, as well as variability in headline income. Typically this means diversifying across a range of asset classes to protect a portfolio from the ravages of certain stages in the investment cycle. It is also important to invest globally, to limit the impact of variations across economic cycles and the effect that this can have on investments locally. Investors should remember that any source of income has risks embedded and demand will be heavily dependent on the yields on offer from cash.
The key to generating a more stable yield from an investment portfolio is to diversify heavily into different asset classes, namely equities, bonds and property. All asset classes are under pressure because of the liquidity crisis. Investors should not forget to treat cash as an asset class and, if income is too expensive or risky to capture at any one time because of supply and demand, it could be worth considering including other investments, even if they do not contribute to yield. Investing in income is like investing anywhere else – it is important to buy at the “right” price. Assets with different characteristics help to smooth results, while some capital appreciation will improve the real level of income.
The sell-off in shares has resulted in a rising yield from equities. However because of the problems, companies are refinancing their debts through rolling over credit facilities with their lenders, and dividend payments are under pressure. During good times, if necessary, companies finance dividends through debt in the short term, in recognition that dividend growth makes their shares look attractive.
In the toughest of times though, they must use cash flow to finance their businesses, which means that payouts to shareholders are relegated to second place and dividends could be cut or cancelled. Just like many individuals, companies are tightening their belts. This means that when looking for income, selecting the right companies to invest in is critical. Those with healthy cash flows have more chance of sustaining their payouts. Investing in just one market is unwise, so it is important to look for global leaders rather than national champions.
Debt is an interesting area. The income from corporate bonds is potentially attractive with the British base rate at historic lows. There is also room for capital appreciation given the sharp sell-off we have seen over the past year in bonds generally.
Corporate bonds have their risks, but long-term fears for investment grade bonds are probably overdone, particularly for companies that have strong balance sheets and cash flow to support them in a downturn. However, all bonds are not the same in terms of credit quality.
There are also several strategies that seek to generate performance from specialist investing, such as in currencies. There are some big moves in currencies as investors try to establish a rational baseline for exchange rates. There have been big falls in the value of sterling and the value this has on goods generally. It is no different for investors, in that the relative change in currencies can be more important to returns than the performance of the asset invested in.
It makes sense to have a bias toward cash, currencies and investment approaches that are not linked to the direction of the markets. Specialist bonds like high yield and emerging markets debt are beginning to be of interest because of their attractive yields.
Spreads are wide for a reason, so although these asset classes offer diversification and can supplement the yield of the overall portfolio, a good strategy is to have a relatively small exposure that is diversified across several approaches. For example, the income from emerging market debt is more than 10% above American government bonds. Investors should diversify into local currency debt issuance as well as hard currency sovereigns within that.
Property has been an attractive asset class. However, there are risks to capital at this point in the cycle. When investing in property, a good strategy is to diversify across the world and to use a range of approaches to gain access to these markets.
Not every economy is contracting like Britain. There is a risk of missing a rally, so there are opportunity-cost risks in holding zero exposure to this asset class. The rallies in the most oversold and most liquid markets are likely to be swift, while the asset class has positive income and diversification characteristics.
Things are neither as good nor bad as the prevailing view of the herd, so investors should take a long-term approach and enjoy the benefits of diversifying across asset classes and geography.