Income funds: Where to find value at the start of 2020

We examine risks facing income investors, highlight best regions and sectors and make fund suggestions.

This year was a healthy one for investors looking for an income from their portfolios – provided you didn’t hold Woodford Equity Income – as income-producing assets generally met expectations. But will 2020 be an easy ride, or will investors have to search further afield for stable, high or growing income?

Rathbone Investment Management’s head of collectives, Alex Moore, says the risks currently facing income investors are similar to those facing equity investors more generally: primarily political uncertainty and the shape of Brexit. He notes that global leading economic indicators have recently softened, the US/China trade war rumbles on and there is civil unrest in Hong Kong.

“These have as much of a bearing on income equities as growth,” says Moore. “Currency is also something investors need to be particularly mindful of – a lot of UK companies that pay out the biggest dividends have the biggest overseas earnings and are economically sensitive, such as miners, oil, banks and financials. If the pound rises, overseas income translated back into sterling could fall.”

‘Bond proxies’ such as utilities and consumer staples stocks have been bid up to high levels as investors pay through the nose for safe assets, but they could be vulnerable to an inflation shock, warns Premier’s senior investment manager Simon Evan-Cook.

“You should always expect to pay a premium for quality, but that has become very high,” he says. “People are paying up for certainty at the moment.”

UK equity income funds for growing income

Despite the Brexit headwind, the UK stock market remains fertile for income-seekers, managers say. “The elephant in the room is the UK – it looks good value, but for investors it is seemingly all just about a view on the pound,” says Invesco multi-asset fund manager Georgina Taylor. “But the companies paying dividends are quite global. While there is a risk of dividend cuts, there’s not as much as is priced in. If you can shut your eyes and look through the next six months of volatility, the UK looks reasonable value on valuation screens.”

James Menzies, investment director at wealth manager Greystone, agrees UK equity income remains a good bet for growing income, although Brexit and the general underperformance of ‘value’ versus ‘growth’ investment styles have hurt performance in recent years.

Evan-Cook highlights the Schroder Income fund for its value-driven stock- picking process and 4% yield, giving investors options away from expensive bond proxies. Evenlode Income, meanwhile, offers dividend growth of around 3%, and the manager has grown dividends consistently since the fund launched. For small and mid-caps he suggests Montanaro UK Income, which offers diversification and a specialist team that buys quality dividend payers at a reasonable price.

Investment trusts are an ideal way for income-seekers to access growing dividends, because the closed-ended fund structure allows managers to smooth dividend distributions over the long term, says Moore. They do this by holding back cash reserves, which is how trusts such as City of London (LSE:CTY) and Murray Income Trust (LSE:MUT) have been able to grow their dividends consistently over 40 or even 50 years.

Some trusts are also trading on discounts to net asset value, making them look more attractive to long-term investors willing to focus on life after Brexit.

Alternatives for balanced income

Infrastructure funds could have a place in portfolios seeking balanced income, with Menzies’ pick, VT Gravis UK Infrastructure Income, focusing on “long-life revenue streams, often linked to inflation”. One caveat, though: some parts of the infra- structure sector are trading on high premiums. David Thomas, chief executive of Seneca Investment Managers, also recommends holding alternative assets as part of a balanced income portfolio – but through investment trusts, as alternatives tend to be illiquid investments, and open-ended funds can be vulnerable in the event of investors rushing to redeem their holdings.

Seneca Global Income & Growth Trust (LSE:SIGT), a diverse multi-asset trust, holds specialist alternatives trusts paying generous dividends, including Doric Nimrod Air Two (LSE:DNA2), International Public Partnerships (LSE:INPP) and Sequoia Economic Infrastructure (LSE:SEQI). Again, however, be aware of the premiums that tend to be involved.

Thomas suggests that balanced income investors could look to combine such holdings with value-focused equity and short-dated bond funds. “The latter are paying decent yields, have relatively low default risk and are less exposed to the risk of rising interest rates,” he says. Funds to consider include Royal London Short Duration Global High Yield Bond and Royal London Sterling Extra Yield Bond.

Emerging market debt funds for high income

High-yield corporate bonds are those with credit quality ratings of BBB or lower. They can offer higher yields than other types of bond and equities, but the trade-off is higher default risk.

“In fixed income, sub-investment grade bonds and emerging market debt are the highest payers,” says Moore. “Emerging market investing has its risks – liquidity tends to be poorer, credit quality is lower and there is more sensitivity to economic risk – but you get rewarded for that through the more generous yield.” M&G Emerging Markets Bond fund, for instance, currently pays 6.3%.

On the equities side, Menzies says the Schroder Income Maximiser fund offers exposure to large caps and holds at least 80% of its £1.2 billion portfolio in UK stocks. The managers use derivatives to generate higher income, and this is how the fund is able to pay a yield close to 7%. Also in the UK, he suggests the small and mid-cap focused Man GLG UK Income fund could be a good high-paying bet, yielding more than 5%.

Investment grade bonds and proxies

Investment grade corporate bonds with the highest credit quality are an area where current prices don’t reflect the level of risk, says Menzies. He has moved underweight these bonds in the view there is a higher risk of underperformance as credit quality in the sector is falling.

“A greater proportion of the global investment grade bond market is now made up of BBB-rated bonds – the lowest tier of investment grade – than ever before,” he says. “We see a risk of under- performance of this asset class if large institutions become ‘forced sellers’ of newly downgraded assets, as many institutional investors are not allowed to hold sub-investment grade bonds.” He is also avoiding sovereign debt, as at the peak in August more than $16 trillion worth of government bonds offered a negative return to investors if held to maturity.

Meanwhile, investors have also been crowding into ‘cashflow companies’ for years – not necessarily the highest-yielding ones but those with steady cash- flows, says Taylor. Bond proxies such as European consumer staples are not pricing in any risks to continuing growth, and look very expensive compared to value areas like energy and banks that have been “left on the shelf ”. “But they are good dividend payers so, when you get a rotation into these areas, they could start to look quite interesting,” she adds.

Selected active fund picks for income

Source: FE, Morningstar, FT, as at 21 November 2019

Passive plays: How to buy the world for income

Ben Seager-Scott, head of multi-asset funds at Tilney Group, selects five exchange-traded funds (ETFs) for investors who want to access global equity income using a passive strategy.

1) SPDR® S&P Global Div Aristocrats ETF (GBDV)  – invests in companies that have been able to grow or maintain their dividend for 10 years or more, a signal of good corporate governance.

2) Vanguard FTSE All-World High Dividend Yield ETF (VHYG) – holds companies based on expected dividend yield.

3) Fidelity Global Quality Income ETF FGQI) – a slightly more sophisticated option, this ETF starts by eliminating ‘low-quality’ companies with poor profitability and cashflow stability, and then backs higher-quality companies with a higher historical dividend yield.

4) iShares MSCI World Quality Dividend UCITS ETF (WQDS) – another option in the ‘quality income’ space. As well as a quality screen, it only holds stocks that yield at least 30% more than the index.

5) Xtrackers Stoxx Global Select Dividend 100 Swap UCITS ETF (XGSD) – this synthetic (swap-based) ETF with a simple methodology holds the 100 highest-yielding companies across the US, Europe and Asia, weighted by their yield.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.