Income-seeking investors had just started to see dividends recover following the pandemic, but now face a fresh crisis as inflation takes hold and markets turn red.
If, as is feared, a recession is next the situation will worsen as company profits flounder and some firms could go bust.
Experts give their take on strategies income investors might pursue in the current challenging climate and offer fund and trust tips below…
On the hunt: Income-seeking investors are facing a fresh crisis as inflation takes hold and markets turn red
‘As market volatility continues and inflation continues to bite, private investors are on the hunt for income once again,’ says Kyle Caldwell, collectives specialist at Interactive Investor.
‘While far from guaranteed, the prospect of a company paying a dividend gives investors greater confidence in terms of its valuation versus firms that are reinvesting cash back into businesses for future growth.’
Darius McDermott, managing director at FundCalibre, says: ‘With inflation at 9 per cent it’s impossible to mitigate completely, but you can try to limit the damage done to your portfolio.
‘In terms of income, the UK remains one of the best places in the world – our stock market has a 4 per cent yield, which will offset inflation a bit and the stock market has held up relatively well versus global peers in recent months as it has more of a value tilt.’
Jason Hollands, managing director of Bestinvest, also warns that you are not going to get a yield that keeps pace with inflation, and it is best to be straight about that.
He cautions against chasing the highest headline yields, which might not be sustainable in the current economic conditions.
‘There is a great deal of uncertainty about how profits mught be affected by the slowdown.
‘Earnings have been very healthy in the last reporting season and forecasts are still good for this year, but are they factoring in an economic slowdown?’
Hollands suggests investors seek security, income payments that look repeatable, and shares or funds where the prospects for increased divided growth are good.
Meanwhile, he says that at a time when finances are squeezed, with rising fuel and food bills, investors might feel tempted to withdraw more from their investments
‘That is a risky thing to do. You are potentially cutting into the bone of your investments, draining capital from your portfolio when valuations are likely to be down quite significantly, to finance current expenditure.’
What income generating strategies could you pursue?
Equity income funds
Global equity income was the bestselling fund sector in April with £678million invested according to the latest investing industry data, but UK equity income funds remained out in the cold, with £31million withdrawn, says Caldwell.
Over the past year, he says the UK sector has posted outflows every single month, but reckons investors could be missing a trick.
‘The UK stock market has many high-yielding stocks. As a result, UK equity income funds have higher yields than their global rivals. The median yield in the sector is 3.8 per cent compared to 2.4 per cent for global equity income funds.
‘However, with higher yields it is worth bearing in mind that despite offering investors the prospect of higher income today, there are no guarantees that this will result in market-beating returns from a total return perspective.
‘Moreover, dividend growth may also turn out to be more subdued versus a lower yielding trust. In addition, dividends can be cut or cancelled without notice.’
Caldwell says the risk is that a high yield today could lead to a disappointing outcome tomorrow, so investors who want to spend their dividends but also grow their capital need to think hard about how to balance those objectives.
‘One approach could be to hedge your bets by investing in a couple of income strategies that invest differently,’ he suggests.
Investing research: If a recession comes profits will falter and some firms will go bust
The more ‘vanilla’ picks for income-seeking investors are Murray International (yield 4.4 per cent), Fidelity Global Dividend and Law Debenture (yield 3.8 per cent), according to Caldwell.
‘The first two trusts invest in global dividend-paying shares, while the latter invests in UK income stocks.’
But he says City of London (yield 4.9 per cent), which has increased its dividend for 55 consecutive years, tops II’s bestseller list for income strategies among investment trusts.
‘For funds, the passively-managed Vanguard UK Equity Income fund (yield 5.1 per cent) tops the income popularity stakes.’
Hollands says that equity income funds have been overlooked for several years because people have been more interested in growth stocks, but now a regular payment from dividends has become a lot more attractive.
He thinks investors should look towards UK equity income, since London-listed companies are very international in nature and are number one for dividend payout rates.
He suggests Blackrock UK Income (yield 4.3 per cent), Threadneedle UK Equity Income (yield 3.2 per cent) and Temple Bar investment trust (yield 3.7 per cent).
McDermott tips City of London, Rathbone Income (yield 3.9 per cent) if you prefer an open-ended fund or Janus Henderson UK Responsible Income (yield 4 per cent) if you are an ethical investor.
‘You can also diversify your income but yields in Japan and the US are quite low, so Europe and Asia may be an option. I like Schroder Oriental Income (yield 4 per cent) and BlackRock Continental European Income (yield 3.2 per cent).’
McDermott adds that Murray International is a global option which can also invest a bit in bonds, and notes the manager is currently invested in quite defensive companies
Infrastructure
‘Infrastructure offers protection against rising prices, due to its exposure to government-backed and inflation-adjusted income,’ says Caldwell.
He explains this has fuelled increased demand among II customers for FTF ClearBridge Global Infrastructure Income (yield 4.2 per cent) and The Renewables Infrastructure Company (yield 5.0 per cent).
The former has over 90 per cent direct and indirect exposure to inflation-linked assets, he says.
‘The fund invests in a diverse basket of global listed infrastructure assets in various sub-sectors such as water, utilities, gas, and electricity.’
Meanwhile, Caldwell notes that Renewables Infrastructure Company has been benefiting from higher power prices.
McDermott says an alternative to standard equity funds is real assets with inflation-linkage, like renewable energy.
This offers investors the ‘doubly whammy’ of RPI linked – therefore higher than CPI – subsidy payments and higher power prices, he explains.
‘There are many of these types of investment trusts available and despite usually trading on high premiums many of them are trading around net asset value today.
‘They have high dividends. VT Gravis Clean Energy Income (yield 3.5 per cent) is the perfect fund to play this with a diversified portfolio across the world but with about 50 per cent in the UK. This is a great way for income investors to protect themselves from inflation.’
McDermott adds that VT Gravis UK Infrastructure Income (yield 3.9 per cent) is another option with often inflation linked cashflows.
‘It has renewable energy but also other real assets such as GP surgeries, the National Grid or other critical infrastructure.’
Bonds
Government and corporate bonds tended to be ignored while yields were low, but these have moved sharply higher of late and should be on investors’ radar again, according to Hollands
He points out that government bond yields in the US have doubled, and in the UK 10-year gilt yields have risen from 0.95 per cent to 2.27 per cent since the start of this year.
But he warns: ‘Be careful about just chasing high yields from companies with weak credit ratings. It is likely there will be defaults if we have a recession coming in the US and UK.
‘Some companies won’t be able to meet their promises to pay back bondholders. Be very wary about credit quality’.
Hollands tips Twenty Four Dynamic Bond (yield 4.3 per cent).
Natural resources
This sector is one of the few apparent growth stories of the stock market in 2022, and the income that funds can generate is perhaps more of a secondary consideration, according to Caldwell.
But he adds: ‘The natural resources sector, a direct beneficiary of the rising oil price, also has inflation protection qualities, which have become more attractive in the current climate.’
Caldwell notes that the two funds in this sector most popular with II customers, BlackRock Natural Resources Growth & Income (yield 3.3 per cent) and JPM Natural Resources (yield 3.3 per cent), have returned 28.8 per cent and 31.8 per cent in the year to date.
But he says investors should remember this strong performance is now in the past.
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