A world beyond gilts – other sources of income for investors

16th January 2013

The long-awaiting bursting of the gilt bubble may finally be happening. In the short-term it is more of a gradual deflation, but as investors have re-embraced risk, bond markets have started to wobble worryingly. Relying on bond funds for income may now be too risky a strategy. Could it be time to get smarter about finding sources of income? There are a number of niche income options that may be just right for current market environment.  

The need for alternative options is clear. Investors in gilt funds have already lost an average of 1.5 per cent so far in 2013, while 10 gilt yields have risen from 1.87 per cent to 2.04 per cent over the past month. Just in case anyone needed convincing, here is UBS fixed income economist Joshua McCallum explaining why the yield available on government bonds in no way justifies the risk that investors are now taking as explained here on Trustnet.

The same is true globally, with the Federal Reserve now suggesting that the quantitative easing may be put on hold later this year reported on Citywire. As a source of income, government bonds appear to be a busted flush. Corporate credit may have more value, but with the average sterling corporate bond fund rising 13 per cent in 2012 and the yield on corporate bonds looking increasingly weak, investors need to be looking elsewhere.  

Floating rate notes:

The key risk for most bonds is a rise in interest rates, or even the expectation of a rise in interest rates. This makes the yield available on bonds less valuable, pushing down the price. Floating rate notes pay a floating rather than a fixed rate of interest and are therefore not vulnerable to interest rate rises. The interest payment is usually linked to quarterly changes in inter-bank lending rates. As interest rates rise, their interest payments will rise and they should become increasingly popular, though that will also mean that their price will rise.

Citywire highlights Twenty Four Asset Management as a specialist in this area. The group’s Income fund has received the banking of multi-asset managers such as David Hambidge at Premier Asset Management. The fund focuses on European asset-backed securities and has been a relatively pedestrian performer while there has been no expectation of a rise in rates, but should fare well as the economic cycle turns.

Emerging market corporate debt

Emerging market corporate debt is a relatively new asset class. Previously, emerging market companies had little access to global capital markets to raise finance. They were considered too small and/or unsophisticated. But the emerging market boom has changed all that. Fixed income specialist Pimco recently said in a note: “In our view, the risk profile for EM corporates has improved thanks to stronger sovereign balance sheets and economic growth prospects compared with developed markets.”

Emerging market government debt has already attracted a lot of interest, but this has also dampened yields. Emerging market corporate debt on the other hand still offers a higher income than developed market corporate debt, even though many of these companies are considered ‘investment grade’ by the market. Pimco says that liquidity and stability in the sector are improving.

“The case for focused EM corporate bond investing remains compelling based on improved credit fundamentals, a solid macro backdrop, and potentially attractive yields,” it says on Pimco.com

A number of groups now have dedicated funds in this area. Pimco, unsurprisingly, have been early into the market. Aberdeen has a top-performing emerging market corporate bond fund listed in Luxembourg and has recently been adding to its specialist team. There are also a number of ETFs listed in this part of the market.

Pibs and prefs

Phil Oakley of Moneyweek has highlighted two income sources that investors may not have considered. The first is Permanent Interest Bearing Shares or Pibs. These are issued by building societies and listed on the stock exchange. As such, they can be bought and sold through a stockbroker. The
y tend to offer higher rates of interest than bonds or shares, though are exposed to the issuer going out of business.

As Oakley says: “Most Pibs offer to pay a fixed rate of interest forever. However, unlike bonds, there isn’t usually a date when they promise to give you your money back (a maturity date). The interest payments on Pibs are paid gross (before tax is taken off), which means you may have a tax bill to pay unless you hold them in a tax-efficient account …Also, if the building society misses an interest payment, it does not have to pay you more in future years. In investing language, this means the interest payments are not cumulative.”

Oakley also highlights preference shares as a potential source of income. These act as lower-risk shares – investors get preferential treatment over ordinary shareholders, getting their dividends paid first and a greater share of the spoils in the event of a wind-up. Source: Moneyweek

Investment trusts

Well, perhaps not the entire investment trust sector, but there are a number of trusts paying a high income. In most cases, this is simply equity income by another name, but some high income trusts are generating income from interesting parts of the market, such as the Ecofin Water & Power Opportunities fund, or the Polar Capital Financials Income fund. Souce: Trustnet

There are some other options: The Greenwich Loan Income fund, for example, buys collateralised loan obligations. This type of investment became one of the bogeymen of the investment crisis, but decent investments were marked down alongside weak ones and parts of the sector have recovered well. This fund is currently paying over 9 per cent in income, but is exposed to less economically stable issuers, usually rated B down to CCC.

The investment trust sector also houses infrastructure funds, which have been one of the most popular alternatives to bonds, particularly among institutional investors. Their popularity has pushed yields lower, but many trusts are still generating an income of 4.5 – 7 per cent with some inflation-protection. HICL Infrastructure, 3i Infrastructure and GCP Infrastructure are among the investment trusts specialising in this area.

 

As the decade-long bull market in bonds starts to reverse, investors will have to become more canny in their income choices. There are plenty of options, but it requires looking beyond the conventional and if you are unsure especially about the risks involved you really should consider seeking professional advice.

 

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