Time to bail out of these big dividend payers?

Rising interest rates could mean trouble ahead for income-paying funds, but portfolio manager James Brumwell is not yet concerned, says Holly Black.

A rising interest rate environment is a difficult one for income investments. The reason for that is quite simple: as rates rise, the dividend or coupon these investments pay tends to look less attractive, so some investors ditch their holdings and the capital value falls.

James Brumwell, who manages our regular income portfolio, explains: "It is probably easier if you are starting afresh when rates are rising rather than trying to manage an existing portfolio. Rate rises are likely to affect the top half of this portfolio (listed in the table below), but we are still at historically low levels." 

Besides, when the interest rate rise is a measly 25 basis points and another hike is not expected for at least six months, the impact is minimal. Our regular income portfolio is still delivering a yield of 4.14% – down slightly because the capital value of the portfolio has grown, but higher than the yield of the UK stockmarket, greater than the income offered by gilts and comfortably ahead of inflation.

August's long-awaited rate rise did, however, have a detrimental impact among our holdings. Our two preference shares have taken a knock since the previous update four months ago, down 5.75% and 3.14% in capital value terms over the period.

A dividend hard to find elsewhere

However, Brumwell thinks investors fleeing these holdings are moving far too soon. The General Accident and National Westminster preference shares both still yield around 6%, a chunky dividend hard to find elsewhere.

He says:

"NatWest shares have been a spectacular success. You don't want to bail out of something yielding 6% just because gilts are offering 2%. Interest rates will need to go up at least another 50 basis points before gilts start to look like a good investment to me."

One holding that has disappointed is Murray International, down 4.2% since the previous update and the only portfolio constituent with a negative total return since launch. Some 24% of the investment trust's assets are in the Asia Pacific region, which has suffered a bout of negative sentiment in recent months as the trade war between the US and China has ramped up. A further 15% of the portfolio is in Latin American and other emerging markets, which have struggled in the face of the dollar's strength and their own local economic problems.

However, the manager of the trust, Bruce Stout, says stockmarket volatility and poor sentiment towards emerging markets is giving way to calm, with Asian and Latin American stocks beginning to rebound. Brumwell is willing to stick with the trust for now.

Brumwell is feeling more positive about the F&C Commercial Property, which has edged up by 1% since the previous update. He says it looks to have 'regained its poise' after a period of underperformance. He is happy to keep some exposure to property in the portfolio, particularly through a holding that pays such a steady dividend. Indeed, regular payouts have helped the trust deliver a decent 8.5% total return since the portfolio's inception in April 2017.

One conundrum faced by income investors is whether to strive for the highest-yielding options or also to aim for high growth and draw down income from capital gains. Brumwell concedes that simply putting the entire portfolio into the Scottish Mortgage investment trust 16 months ago might have delivered superior total returns. The trust, a 'long-term favourite' of Brumwell's, has delivered a staggering return of 42.5% since the portfolio's inception.

However, he adds:

"Of course, that wouldn't really be in the spirit of what this portfolio is aiming to achieve, and performance won't be as spectacular when the stockmarket falls or moves sideways."

Arguably, after such a strong run, now is the time to pocket some profits, but Brumwell points out that it is still not the largest holding in the portfolio, adding that he would be more inclined to buy rather than sell.

He says:

"There is an argument for rebalancing your portfolio and the trust has a large exposure to the US, but it doesn't account for an overly large proportion of assets, so I'm not concerned."

Income star

The New City High Yield Fund has disappointed in terms of capital growth, but it produced the greatest income among our portfolios, with £508.30 pocketed since inception. The TwentyFour Income Fund was purchased at the previous update and has largely performed as hoped: it was a stable presence even as markets turned volatile. Meanwhile, another investment trust holding, Invesco Perpetual Enhanced Income, is under surveillance after another period of poor performance; the total return of the trust is only being kept in the black by its dividends.

While Trump, Turkey and trade tariffs will be on the minds of many investors in the last quarter of the year, Brumwell insists "you have to be able to ignore the political side of things".

His only macroeconomic concern is whether the market could be surprised by interest rates rising faster than expected. It doesn't seem likely, particularly with Brexit negotiations still being thrashed out, but it is an event that could cause most harm to this portfolio. Despite that, however, he points out that the strong performance produced by many holdings so far should provide a cushion for the portfolio.

He adds:

"We may have to make adjustments before the end of the year, but I'm satisfied with how we are doing: we're looking for income and we've got that, and it has edged up over the life of the portfolio. Hopefully, that will continue."

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