197. Why interest rates are likely to go higher in the UK
Job Curtis, manager of City of London Investment Trust, discusses the UK stock market and why it has...
Bigger isn’t always better. This is true in many ways, including when it comes to investing – but even so, sometimes it’s hard not to be seduced by extraordinarily high yields. An investment offering income in excess of five or six percent is enough to make anyone go weak at the knees. A high yield alone often isn’t enough though. The question you really need to be asking is: is it sustainable?
Too often, the answer may be no. Although the ‘search for yield’ has become a familiar lament, BlackRock’s chief investment strategist, Ewen Cameron Watt, phrased the income investor’s problem a little differently when I caught up with him earlier this year.
“The obligations of savers are long term,” he said, “and you need assets that are going to continue to pay out, relatively reliably. We should be talking about the search for duration [i.e. how long the income will last], not the search for yield.”
He makes a good point. If you’re investing now to retire in 30 years, a fund that pays a yield of 6% today is not much good to you if it can’t sustain that rate. Nor is it ideal if it manages to sustain it only by sacrificing capital growth or by putting your capital at ever-higher levels of risk.
Bond yields have been falling for three decades. In recent years, investors have flocked to large blue-chip stocks instead, in the hope that these companies will offer the kind of stable, reliable income they had previously sought from bonds. This has helped to push up the value of the blue-chip stocks, many of which have come to be known as ‘bond proxies’.
The problem is that these bond proxy companies haven’t necessarily increased their earnings in line with their popularity among investors. So their stocks have become very expensive relative to their growth potential. This is particularly the case in the US, where the stock market continues to trade around all-time highs. It is fine while it lasts, but stocks at these prices can be very vulnerable to market shocks.
Bonds meanwhile present a problem because if we are at the start of a rate raising cycle, any bonds already bought will become less valuable as interest rates increase. Plus with inflation picking up, your ‘real returns’ from bonds—meaning your returns after accounting for inflation— may struggle to keep pace.
Learn more: What is a yield curve and why should you care?
If you’re researching a few different income options though, how can you tell which ones are more likely than others to deliver a sustainable yield over the long term? We highlight a few options that FundCalibre rates, which may fit the bill.
One option is to invest in bonds with a higher yield, although it’s important to remember that these bonds can put your money at more risk, because the companies and governments that have issued them are generally considered to have a higher chance of defaulting. You also need to look for funds that are taking steps to make sure they can sustain their level of yield over the long term.
A fund like the Elite Rated Aviva Investors High Yield Bond mitigates default risk somewhat by diversifying in around 80 to 100 holdings. What’s more, the different bonds in the portfolio should mature at different times, hopefully helping to deliver a durable income stream over many years. The manager, Chris Higham, spends a lot of time analysing companies’ cash flow and ability to repay their debt before he buys any bond.
You could also take a look at the Elite Rated Schroder High Yield Opportunities, which currently has around 140 different bonds within its portfolio. The fund is a long-term performer among the very best in its peer group, outperforming the sector consistently over the past ten years.
On the equities front, the key is to find a manager who thinks not just about dividend yield today, but also about dividend growth for tomorrow. This may mean that not every stock in the portfolio is high yielding at the point of purchase, but overall the fund aims to produce a reliable income that keeps on growing.
Thomas Moore, who runs Elite Rated Standard Life Investments UK Equity Income Unconstrained, is one such manager. He looks outside the typical income-producing bucket to search for stocks with growing earnings that he believes offer the potential for dividend increases too. Similarly investing in the UK, Elite Rated Rathbone Income also has a very impressive, long-term track record. In 24 years to the end of 2016, it has increased its income distribution year-on-year for 23 of them¹!
If you’re after international income, Matthew Page and Ian Mortimer, who run Elite Rated Guinness Global Equity Income, are two physicists who believe their focus on cash flows and high returns on capital helps them to pick out the dividend-payers of the future. And although income isn’t typically the focus of emerging markets equities, the Elite Rated Charlemagne Magna Emerging Markets Dividend seeks dividend-paying stocks in niche areas that may often be overlooked by other funds. Jason Pidcock, the manager behind Elite Rated Jupiter Asian Income, is another who splits his investments between high yielding stocks now and companies he thinks will pay out in the future.
Income seekers may also like to consider investment trusts, which are another type of fund. Investment trusts can use a revenue reserve to help them deliver a sustainable income over the long term. Basically, this means they are allowed to keep aside some of their dividends each year and dip into this pot in years when dividends may not be so plentiful, so the trust can keep paying investors steadily. Two excellent examples include Scottish Mortgage Investment Trust—a portfolio of global stocks that has cut its dividend just once since it launched in 1909—and City of London Investment Trust, which invests in UK equities and has delivered 50 consecutive years of dividend increases.
¹Rathbone Income annual distribution payments, Rathbone data, 1993–2016