Fund and trust ideas to income-boost portfolios to beat inflation

Four types of funds yield 5% plus. Cherry Reynard runs through the options, risks and potential rewards. 

Between a cost-of-living crisis looming and increasingly wobbly markets, a 5% income seems like a welcome safety blanket. However, high yields can also be a red flag, a sign of an investment in decline. With that in mind, investors need to look at whether high headline yields are sustainable and – just as important at a time of rising inflation – whether that income can grow over time.  

In general, there are four types of investment that generate a yield in excess of 5%. The first are conventional equity income strategies. With most strategies paying 3.5% to 4%, investors looking at 5% will generally be shopping in the ‘enhanced income’ (where the fund manager uses derivatives to enhance the yield) or deep value (where the manager invests in unloved companies) end of the market. Two such funds are Schroder Asian Income Maximiser and Premier Miton Optimum. Both have a dividend yield of 6.9%.    

The second type of high-income fund operates at the farther reaches of the bond market – either emerging market debt or specialist debt strategies. The latter feature heavily in the investment trust market, where there aren’t the liquidity constraints that open-ended funds face. The Baillie Gifford Emerging Markets Bond fund, for example, has a yield of 6%.

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There are also specialist property funds. Conventional property has staged a strong recovery in 2021, but some areas have been left behind. Again, many of these are found in the investment trust sector. Regional REIT, for example, pays a 7.3% yield. This will also include quasi-property assets such as infrastructure and, in particular, green infrastructure – solar and wind farms, for example.

The final area is ‘speciality finance’. These are esoteric lending strategies and can be very niche. The BioPharma Credit Trust (LSE:BPCR), with a yield of 7%, lends exclusively to the biotechnology sector. Another example is the real estate lending specialist Real Estate Credit Investments (LSE:RECI), which has a yield of 7.6%. Some funds offer a diversified lending portfolio – the TwentyFour Select Monthly Income (LSE:SMIF) is an example. Its yield is 7%.

Sustainable income

High yields can arise where the share price has fallen significantly in anticipation of a dividend cut, but that cut has yet to be declared. The same is true with income strategies in the investment trust market. With this in mind, determining the sustainability of an income is vitally important and will vary with the type of income strategy.

Equity income has a tailwind today. There has been a widespread dividend revival. The most recent Henderson Global Dividend index report showed 90% of companies either raising dividends or holding them steady. Restrictions on bank dividends have been lifted globally. Also, dividend stocks have been significantly out of favour as investors have chased growth stocks, leaving valuations looking appealing.

Thomas Moore, manager of the Aberdeen Standard Equity Income Trust (LSE:ASEI), which currently sits on a 6% yield says: “People have grown used to high yielding equities meaning a value trap. I really disagree with that view. Right now, those same companies yielding 5% to 7% are seeing the best earnings upgrades, the strongest pricing power. These companies have high yield and high earnings momentum - there is no trade-off. Some of the high yield stocks we own have the best operational momentum in the entire market.”

Away from equity income, James Carthew, head of investment company research at QuotedData, says that many of the high yield options in the investment trust sector should be sustainable, but advises caution on the very highest yields. He says: “There are trusts paying 12% to 13% yields, but these are invested in complex debt funds, which are often quite risky. These have performed fine because there has been a lot of support for businesses, but we might see more defaults if the environment becomes more difficult.”

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Some of the credit funds, however, look more secure. He highlights Honeycomb Investment Trust (LSE:HONY), which does speciality loans. It has a yield of 8.2%. TwentyFour Income Select Income has also seen reasonable performance and the yield should be secure, according to Carthew.  

Some of the property funds on the highest yields are also struggling, he says, particularly those with large weightings in regional offices. Carthew is far more optimistic on the prospects for the various infrastructure, solar and wind options.

He says: “Inflation helps the subsidies, and cash flows are index-linked as well. It is interesting how much the power process has moved.”

Carthew points out that some of these trusts are at a small discount to their net asset value (NAV) after a lacklustre year in 2021. He highlights Greencoat UK Wind (LSE:UKW), Foresight Solar (LSE:FSFL) and GCP Infrastructure Investment (LSE:GCP). He also likes Civitas Social Housing (LSE:CSH).  Carthew adds: “This is doing something great and deserves to grow. Its yield is cast iron.”

The capital growth conundrum

In recent years equity income has been a dismal strategy. Investors have had to watch their investment trail the wider market. The technology shares that led markets higher don’t tend to pay dividends, so haven’t been an option for equity income fund managers. The average fund in the Investment Association’s global equity income sector has lagged the average fund in the global sector by over 16% over the past five years.  

At a time of rising inflation, investors need their capital to grow, or risk it losing its purchasing power over time. The Bank of England estimates that inflation may peak at over 7% this year. Investors need to be reassured that their income strategy doesn’t provide income at the expense of long-term growth.

Nevertheless, a changing interest rate environment may bring better times for income investors. Dr Ian Mortimer, portfolio manager on the Guinness Global Equity Income fund, says: “Dividends appear to be coming back into favour. We have seen returns driven by multiple expansion in 2020, then by earnings growth in 2021.

“In 2022, earnings growth is likely to be more muted amid rising rates and slower economic growth, while prospects for multiple expansion appear low – so the dividend part of total return may become a greater proportion of (likely modest) total returns in 2022. The generally more reliable nature of dividends (compared to earnings) may also be seen more favourably.” 

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Moore adds: “Some traditional companies are producing such strong cash flows, it’s harder and harder for people with a growth bias to ignore them. The old-fashioned concept of a yield actually means something…. people have ignored perfectly solid businesses with strong cash flows. That’s what set the change. Not many fund managers have maintained the discipline of looking at a company’s cash flows, but it is coming back.”

Gary Potter, joint head of the multi-manager people team at BMO GAM, agrees that income strategies may stand a better chance of growing capital in today’s environment:

He says: “We are seeing higher inflation and a higher level of yields. Income strategies are a very good way of building wealth. Looking at total returns over 25 years, 70% comes from income. This has been almost completely forgotten by the market.

“If an investor starts with a 4.5% to 5% yield, it is a significant boost, particularly in years where capital returns aren’t exciting. We’ve had the exciting years. Equity income is the most underrated, under-appreciated sector out there.”

It is worth noting that many of the ‘lockdown winners’ – Peloton Interactive (NASDAQ:PTON), Zoom Technologies (TSX:ZOMD), Meta (NASDAQ:FB) – have seen their share prices slump so far in 2022.

However, investors shouldn’t mistake income stocks for deep value. Carthew points out: “In this inflationary environment, if you’re not a decent company and can’t pass through price rises, you’re going to be in trouble. Quality is important. Investors can’t simply buy anything on a big yield.”

For some of the bond strategies, income growth is not assured. Overall, the outlook looks bleak for bonds, with inflation at high levels and interest rates rising. Infrastructure or other property strategies may offer more protection against rising rates because their cash flows are index-linked.

It has been a tough time for those who need an income from their investments, but the market is shifting to favour an income approach. At a time when markets may deliver little in the way of capital growth, a regular income can be reassuring. With some discernment, a reliable 5% income is achievable.