INVESTMENT UPDATE

Outlook for Income Investing - March 2021

  • 03 March 2021
  • 10 mins reading time

On Tuesday 23 February, we produced a webinar addressing the outlook for income investing. The main speaker was Head of Income Solutions at Schroders Investment Management, Rupert Rucker. This briefing is a summary of the information he shared.

The good old days

In 1986, you could buy a National Savings Certificate that offered a return of 8.75% a year for five years. National Savings Certificates were backed by the government, so the risk associated with them was about as low as you could get, referred to by many as “risk-free”.

Today, you’d be lucky to get 0.5% from a government-backed investment such as a savings deposit account with a bank.

So what has changed and why does Rupert Rucker think that investing today offers an excellent opportunity?

What’s changed?

In the 1980s, the UK economy was undergoing a major restructuring process leading to substantial shifts in inflation and economic growth, as Chart 1 shows.

Since then, central banks have sought to bring interest rates back to historic lows in order to aid economic recovery following the financial crisis a decade ago and the more recent pandemic-driven lockdowns.

This has led to a sharp increase in the demand for bonds, especially ones with lower-risk ratings. These bonds were seen as offering a “haven” in which investors could place money while stock prices sank. What’s more, with interest rates so low, investors looking for a source of income would be likely to receive proportionally low returns on their bank deposit savings i.e. bank deposits became less attractive relative to bonds. That spurred the search for relatively low-risk alternative income-generating investments, not least of which were bonds.

As the demand for bonds rose, their yields fell (the price and yield of a bond always move in opposite directions).

Since 2008, interest rates have been extremely low and so have government bond yields and bank deposit interest payments. What’s more, companies have cut or suspended dividend payments to shareholders while they allow their revenues to recover following the lockdown restrictions.

What can we expect?

Inflation rates might pick up from their current lows over the coming year or two as financial stimulus is provided by governments and central banks. But we don’t expect inflation to exceed the sweet spot of around 2% for too long.

One reason for this is the “slack” that exists in the economy at the moment. In other words, as prices increase companies will be able to increase their production and delivery levels drawing on the availability of unused resources. These resources include people looking for jobs as well as plant and equipment that might not be a full capacity at the moment.

The consequence is that we have to think differently about the investments we choose today in order to generate an income stream.

What can investors seeking income do?

There is some good news here. As Chart 1 shows, inflation is more stable and predictable than it was back in the 1980s. That helps to reduce the uncertainty when making investment decisions.

With interest rates also being low and, in our opinion, likely to stay low for the foreseeable future, the cost of hedging is extremely cheap. Hedging is a form of insurance against losses that might come about, for instance, as a result of changes in the value of the pound relative to other currencies.

For example, if a UK investor bought Australian government bonds and then the value of the pound rose then the value of those bonds when sold and exchanged back into pounds sterling would be reduced.

Hedging allows an investor to have an automatic counterbalance against such currency changes. And with hedging being so cheap at the moment, that enables investors to choose from a broader range of markets and asset classes without paying as much as they would previously for hedging.

What this boils down to is a greater opportunity to diversify.

More diversification is likely to be needed

That opportunity is very timely.

Investors cannot rely on the traditional income-generating asset classes such as UK government bonds because they simply don’t pay a high enough dividend and don’t look likely to while inflation and interest rates remain low.

However, by investing in a carefully selected blend of income-generating assets from a much broader range of opportunities, investors can create an income-generating portfolio without taking on too much risk.

Chart 2 provides an example of this. The horizontal axis measures volatility, how quickly the price changes; a common measure of risk. The vertical axis measures current yield, a simple indication of income.

Government bonds are among the lowest-risk rated investments with US 10-year Treasuries having a volatility or risk measure of around 4%. But their yield is tiny at less than 0.5% at the time the data were collected.

At the other end of the scale are Real Estate Investment Trusts (REITs) which can offer a current yield of just over 4%, but have a risk-rating of nearly 19%. That’s a very high level of risk for that level of income.

By blending different income-generating assets it is possible to create a portfolio with a risk rating of 8% and a current yield of 4%. The GMAI dot in the chart represents the point at which a global mix of assets for income can have such a balance of risk and return.

Putting a portfolio like this together requires a good deal of research and analysis, and could be beyond the reach of many retail investors. However, there are income-generating investment portfolios which retail investors can buy into.

Words of caution

There are two factors that Rupert believes investors must adhere to if they are to improve their chances of building a successful investment portfolio for income.

Firstly, more risk has to be taken than was the case in 1986. As Chart 2 shows, we can no longer buy relatively risk-free investments and watch them generate income. Those days are over. So investors wishing to earn income are going to have to take more risk and that requires a good deal of research and careful blending of assets to manage that risk.

Secondly, the higher level of risk requires that the investments be allowed more time. The greater the amount of time invested, the more likely that the actual investments will match the example profiles shown in chart 2. According to Rupert, a bare minimum investment horizon should be five years, if not 10.

Conclusion

The world continues to throw challenges at investors, but the scope for choice and opportunity now is greater than it has been for a long time. That said, an extra element of risk accompanies these choices, but that level of risk can be managed by spreading investments through diversification. By combining these factors, it becomes clear why Rupert Rucker is optimistic about income investing today.

Important information

Any views expressed are our in-house views as at the time of publishing.

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In preparing this article we may have used third party sources which we believe to be true and accurate as at the date of writing. However, we can give no assurances or warranty regarding the accuracy, currency or applicability of any of the content in relation to specific situations and particular circumstances.

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