Funds and trusts yielding more than cash that the pros are backing

Achieving a high and rising income on a portfolio has become a whole lot easier due to rising interest rates. It has also become more important. With the level of interest paid on top savings accounts now reaching 5%, there is greater competition for investors’ capital.

After a decade of scarcity, income is abundant. Higher interest rates have lifted bond yields, while dividends have also been resilient, leaving many equity income funds paying chunky yields. At the same time, a tough period for the investment trust sector, and specialist property and infrastructure funds in particular, has left yields at decade-high levels.

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In early December, there were 198 open-ended funds and 166 investment trusts paying more than 5% income, according to Trustnet. There are areas where this may indicate distress, such as some of the specialist finance trusts, but for the most part, these high-yielding investments are conventional corporate bond or equity income funds. The “reach for yield”, where investors had to take more and more risk to achieve dwindling levels of income, appears to be firmly at an end.

Headwinds for both equities and bonds

There are risks for both equities and bonds in the year ahead. Bonds remain vulnerable to any rise in inflation. Some rise in corporate distress appears inevitable as the economic environment weakens and companies have to roll-over their debt. Credit spreads – the level of income paid by a company over the prevailing government bond yield – are at their lowest level in 18 months and may not reflect any imminent economic weakness.

Eduardo Sanchez, research analyst at Square Mile, says: “While some strategies are yielding 8%-9%, the concern is that if we go into a recessionary environment, default rates will rise and credit spreads will have to widen. The managers we talk to are reducing their exposure to lower-rated companies to avoid the more dangerous options. When these companies have to refinance at higher rates, it could be a problem.”

This argues for ensuring that any corporate bond exposure is skilfully managed. Sanchez likes the Schroders Strategic Credit fund run by Peter Harvey, which has a high yield, but focuses on short-dated BB-rated credit. “It has given very stable returns,” Eduardo adds. He also likes the Vontobel TwentyFour Strategic Income fund, which combines government bonds and investment grade rated bonds, which are relatively low risk.

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Gavin Haynes, investment consultant at Fairview Investing, picks the Rathbone Ethical Bond fund, saying a peak in rates could be the catalyst for a bounce-back in bonds. He says: “I like this fund for core exposure to corporate bonds. It is primarily investment grade sterling bonds and its fund manager Bryn Jones follows a thematic process after which the team carry out credit analysis to find the assets that work best within the thematic framework. It aims to provide an attractive level of income (with a current yield of 5.1%) and has a well-diversified portfolio of over 200 positions.” The fund is a member of interactive investor’s Super 60 list.

He also suggests VT RM Alternative Income, a portfolio of specialist high-yielding investment companies focused on three key themes, infrastructure, real estate and specialist credit. He adds: “There are some really interesting opportunities in this space with many investment trusts trading on large discounts, but you need specialist knowledge, which fund manager Pietro Nicholls certainly has, and it feels a better option to invest in a fund with an actively managed diversified portfolio as opposed to picking a couple of trusts yourself.”

Property: treading carefully

Property used to be a stalwart of many income portfolios, seen as a reliable option for inflation-adjusted income and steady capital growth. However, it has been a troublesome sector more recently. It has had structural problems; there has been a move away from bricks and mortar retail, while the work-from-home phenomenon has put pressure on the office market. It has also suffered outflows as investors have returned to fixed-income assets. This is particularly true for infrastructure investments, which had been a source of high income at a time when there were few other options.

It is perhaps too soon to say that all these problems have been resolved, but with interest rates stable, and many property trusts on significant discounts, there are selective opportunities emerging within the sector. Adam Horsley, private client investment director at Tyndall Investment Management, suggests the Schroder European Real Estate Inv Trust (LSE:SERE): “It trades at a deep discount of 37% to its net asset value. It is yielding 8.4%. The trust has a diversified portfolio of European commercial real estate in primary cities in France, Germany and the Netherlands, which offer better growth potential due to their GDP, population, employment, transport and storage facilities.”

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The managers are also taking the impact of climate change seriously, commissioning sustainability audits across the portfolio. Horsley adds: “We believe that investments with green certification will outperform over time and that poorer-quality assets will become increasingly obsolete and illiquid.” He also points out that all the trust’s leases are subject to indexation, which provides an inflationary hedge. He says: “As we move into 2024, a number of headwinds facing investment markets look to be easing, led largely by peaks in inflation and interest rates, which should benefit this trust.”

Louis Tambe, head of the managed portfolio service for City Asset Management, believes the worst may be over for infrastructure assets as well. He likes NPP, which invests in a wide range of infrastructure assets across the UK and globally: “Roughly one-quarter of the portfolio is invested in the cables which link offshore wind farms to the mainland grid in the UK, where the fund receives a secure income stream linked to inflation. In their last financial year, they transported enough renewable energy to power 2.7 million households in the UK. They are also building the new London Tideway project under the River Thames which, once operational, will reduce discharges in a single year by 37 million cubic metres.” At the current share price, the trust yields just over 6%.

Stock markets

Within equities, the UK still looks like an attractive option with 11 UK equity income investment trusts paying higher than 5%. This includes popular UK equity income “dividend hero” trusts City of London Ord (LSE:CTY) and Merchants Trust Ord (LSE:MRCH). The fund managers are confident about the sustainability of dividends, and also have dividend reserves to support payouts.

With many UK equity income trusts on discounts, investors could get the double whammy of narrowing discounts and rising asset prices. 

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Simon Gergel, manager of the Merchants trust, says: “There have been lots of reasons to avoid the UK, so the valuations have come right down…companies have been buying back a huge amount of their shares. They’re generating a lot of cash and their equity is very cheap. In the UK, an investor is paying £10 for every £1 of profit. That’s the cheapest it has been in 20 years. In the US, you’re paying around £20 for every £1, the highest it has been for 20 years. Even if you adjust for the sector make-up, the UK is still very cheap. There’s lots of opportunities to buy good companies at bombed out prices.”

Specialist funds

There are also a number of specialist options, mostly within investment trusts. Ben Conway, head of fund management at Hawksmoor Fund Managers picks the Twenty Four Income fund. This has a running yield of over 10% at the current share price. He says: “This investment trust owns a portfolio of Residential Mortgage-Backed Securities and Collateralised Loan Obligations. The floating rate coupons on these underlying instruments are directly linked to short-term rates meaning the income received by the trust increases as base rates move higher.” He is comfortable the dividend can be sustained, pointing out that it comfortably paid a 6.5p dividend in the nine years prior to 2023, when interest rates were at rock bottom.

Tambe suggests Assura (LSE:AGR), a fund investing in GP buildings across the UK, creating more capacity for the NHS to provide essential services. He notes: “The costs of building new GP surgeries are significant to the NHS and Assura provides these buildings to a very high standard without the direct up-front costs to the NHS. They have been continuously investing in their portfolio, upgrading the EPC ratings of their buildings to minimise their carbon footprint, and are building one of the first net-zero developments in the sector in Fareham. At the current share price, the trust yields just over 7%.”

For the first time in more than a decade, investors have a breadth of options to generate a high and sustainable income. There are a range of equity, bond and property investments to tempt them out of cash. The era of income scarcity appears to be over.