With interest rates at historic lows, albeit poised to increase, investors are having to look further for income that in the past had been ensured by savings accounts and gilts. Income investing is the process of selecting portfolio holdings which will deliver a steady stream of income over a certain period of time. This goal can be achieved in a number of ways, including owning corporate or sovereign debt, or equities that pay dividends. An income investor has the option to pick securities independently or rely on the manager of an income-seeking fund.
Income investing is in contrast to buying assets due to a perception of attractive valuations and an expectation of future appreciation, thus creating an opportunity to sell at profit.
Seeking Yield in Fixed Income
Bonds are often considered central to income investors because of their nature of delivering fixed rations of income over set intervals. Seeking income in debt markets has an element of seeking shelter from risk, particularly in the high-quality space occupied typically by high rate bonds issued by stable governments.
Even within the fixed income space there are varying degrees of risk, however. High-yield bonds, for example, are securities that pay a fixed interest but are below investment grade bonds—their risk of default is relatively high and therefore their providers pay out higher yields to the bond holders who are willing to accept the relatively higher risk involved. A metric often sited alongside high yield bonds is the spread between these securities and high quality, lower risk fixed income, such as gilts or treasury bonds.
High-yield open-end funds have seen a surge of interest so far in 2011 and as such have posed an investment dilemma. The sector’s strong rebound after the credit crunch has slowed down, while at the same time strong investor demand has pushed companies to issue new bonds in order to finance new acquisitions rather than refinance existing leverage, which eposes debt holders to additional risk. “Some allocation to high yield still makes sense today, especially to diversify a high-quality bond portfolio, but today's low absolute yields and limited upside hardly signal an attractive entry point,” says Morningstar’s associate director of fund analysis Miriam Sjoblom.
Seeking High Dividend Companies
Looking for income on equity markets boils down to considering attractive dividend opportunities. There are several considerations to keep in mind. One of the ways that companies redistribute profits to shareholders is in the form of dividend payments. It is more commonly those companies that are no longer in expansion mode and therefore opt to reward their investors rather than reinvest profits in the company. Thus, income-focused investors often look to older and more established companies for attractive dividends.
It is important to recognise, however, that a company’s dividend policy can be an indication of a number of corporate strengths and weaknesses. For example, there’s no guarantee that a company will be able to achieve its projected dividend growth, as was seen in 2010 when BP was forced to cancel its dividend following the Macondo well explosion. In addition, a company that redistributes high dividends will have less capital to reinvest and contribute to its own growth, which in turn could inhibit its ability to maintain high dividends. Thus, a history of having attractive dividends is a helpful indicator to consider when seeking yield. Finally, a heavily-indebted company may struggle more than less-leveraged peers in maintaining a steady dividend stream in tough market conditions.
There are a number of industries which have historically held appeal for yield seekers, utility providers and real estate investment trusts being two examples.
Inflation and Interest Rate Risks
There are a couple of key risks in the current environment, namely the low interest rates offered and the risk posed by above-target inflation, which may erode the appeal of securities paying a fixed interest or equity dividends.
In terms of fixed income, the longer a bond’s duration, the more exposed it is to the risk of rising interest rates. Fixed income funds could offer a degree of duration diversification and a hedge against the effect of interest rate hikes, but it is important to acknowledge that the more diverse the duration mix, the harder it is to measure the impact of monetary policy changes. The mechanics of duration are complicated, and not every fund is sensitive to rising gilt yields, but one useful rule of thumb is that for every 1-percentage-point increase in market yields, you might expect a fund to lose an amount roughly equal to its duration.
