Amidst all the noise that surrounds the investment world today, it is easy to forget the basic factors that drive investment choices. Individuals need money to live their lives the way they want to; they need food, shelter and security. All investments provide return in two forms: capital gain and income. The conundrum investors are facing in today’s world is that the income component of their portfolios is at historically low levels and prudent investors are reluctant to raid their capital to provide for living expenses.
Low interest rates have been driven and accentu-ated by historically low sovereign bond yields. The UK 10-year Gilt yield has tightened since the early 1990s but much of it has come in recent months.
This means the ‘cost’ of income security in real terms has become very high. Consequently investors and their advisers have had to broaden their search for yield into riskier and more diverse assets than those to which they might have traditionally been exposed. The question we must all continually address is whether this broadening of the traditional universe has acted to increase overall risk in portfolios, or if it has acted to drive strong returns and improve diversification.
One simple way to increase the yield on a portfolio is to start focusing on high yielding equities at the expense of lower or zero yielding stocks. Historically ‘growth’ companies have tended to pay out lower div-idends in return for higher capital growth. This rela-tionship has, however, broken down with the advent of financial engineering and many of the companies that have provided the best total return over the past decade are also among the highest dividend payers.
This phenomenon has not gone unnoticed in the market place, with many new ‘equity income’ strategies springing up, with very variable outcomes for investors. Fund returns within Citywire’s UK Equity Income cate-gory have ranged from +7.8% to -10.1% for the year to 30th April 2012.
It is therefore vital to ask yourself what drives this divergence, especially within what is a relatively tight universe. The answer is that it is all too easy to get seduced into buying high dividend stocks that look safe on paper, but which need to offer sky high yields to attract investors. Those burnt by the demise of banking stocks in 2008 can testify to this; few were immune.
So the moral we take from this is that while hunting for strong equity yields has provided real value for dec-ades, it is important not to forget the basics of investing in high quality businesses.
The traditional source of income in portfolios has been from bond markets. At the risk of stating the obvious, the great advantage of bonds is that at the point of purchase you know exactly what your income f low will be and you know when your capital will be returned to you, barring the possibility of default. This contrasts with equities where there is a possibility of capital gain and the possibility of gaining more income (via dividends) than you expect.
There are two key variables in bond markets that have a dramatic impact on returns: the duration of the bond, and its credit quality. It is in the relationship between these two variables where opportunity arises for inves-tors to significantly increase the yield on their capital. This is often enhanced by the restrictions to which indi-vidual investors are bound by; some may not be able to buy sub-investment grade or long duration bonds, for example. These restrictions create a slightly distorted market, which means a skilled manager may be able to extract an increased return for very little extra risk.
The clearest example of this can be found in the cur-rent high yield market. Many investment mandates pro-hibit ownership of junk bonds, despite their significantly improved fundamentals and relative resilience of late.
Another large and growing class of bonds worth keeping an eye on are those issued by Emerging Market companies and governments. In many cases the eco-nomic fundamentals underlying these bonds are signifi-cantly better than their developed market counterparts, but many large institutional managers cannot buy them. This creates a cheap lunch for unconstrained investors.
Other forms of yield
So, if equity income has the pitfall that you can be seduced into buying bad companies and the bond market is currently characterised by tight yields and herd mentality, where else can you look for yield?
The traditional third pillar in the search for yield is to be found in the property markets. Buying property is very like investing in long dated bonds; when you own a building you get a rental stream, which, in theory, can raise in line with inflation. However, these properties usually trade more like equities, in that when you wish to sell them, you may find yourself on the wrong end of some serious capital volatility. One way around this is to invest in very large pools of real estate, such as the iShares Developed World Property Index Fund, which currently has a yield of 3.1%. The volatility, however, can be terrifying; over the last five years this security has traded in a range of $28 to $8.
One final way of generating yield for sophisticated investors is to use the options markets. The high level of volatility in markets has led to options becoming very valuable. This means if you own a basket of equities, you can write calls and in the event of flat markets, you will receive premiums. A more aggressive policy, if you are holding large amounts of cash, is to write puts. If you do both of these, you can generate a significant income, but at the risk you may either buy or sell large quantities of equities. Tax considerations are paramount here.
So where does this take us in our search for yield? In general, it takes us to lower quality, less liquid assets. The most important conclusion is you must continue to diversify your sources of income and not concen-trate investments in any one area, even if you sacrifice some potential yield. Ultimately, capital preservation is more vital than current yield and you neglect that at your peril.
