How to avoid the yield trap
The yield trap, defined as the perilous pursuit of income in the face of contrary market indicators and/or friendly advice, is a term many investors will be familiar with. It alludes to a very simple investment premise: that the bigger the potential payout, the bigger the risk, and that, should this risk not pay off, you can find yourself in trouble.
In recent years, investors have been forced into a collective state of amnesia regarding this premise.
Rock-bottom interest rates and suppressed market yields have driven most to seek out riskier assets to meet their income needs and desires.
However, with the US, home to the world's largest economy, expected to raise interest rates in September, now may be a good time for investors to re-evaluate their portfolios.
THE HUNT FOR YIELD
The financial crisis of 2008 was both a blessing and a curse for many UK investors.
While the influx of £375 billion of quantitative easing from the Bank of England (BoE) has boosted equity markets significantly, it has also suppressed interest rates and bond yields, hurting cash savers and traditional income investors.
As the BoE's base interest rate plummeted from 5.75 per cent in 2007 to 0.5 per cent in 2009 (where it has sat ever since), cash interest rates followed suit. Today, the average cash Isa pays just 1 per cent. At the same time, the 10-year UK government gilt yield plunged from 5.2 per cent in mid-2007 to just 1.6 per cent by mid-April this year.
Inevitably, this has forced some savers and investors into alternative income-bearing assets, such as high-yield bonds, equities and commercial property, which has depressed yields more widely. As this cycle continues, investors are being forced further and further up the risk scale, putting their capital at ever greater risk to find the yield they need.
According to some commentators, this situation is approaching a tipping point. David Coombs, head of multi-asset at Rathbones Investment Management, says: 'Because we have had a huge wall of money going into any asset class with an income on it, we are in a situation where income investors are probably at the highest level of risk they have ever been, in terms of both their capital and the sustainability of that income stream.'
It's easy to understand why this situation has developed. Yields on sub-investment-grade bonds are at record lows as investors continue to pile in, despite default risks.
European junk bonds are currently paying an average of just 4 per cent, yet have attracted €19 billion (£13.7 billion) from investors since 1 January alone. Increased demand for equities has sent share prices soaring, despite, in many cases, a lack of earnings on these shares.
According to Hugh Yarrow, manager of Money Observer Rated Fund Evenlode Income, this is making mainstream equity investing increasingly difficult. He says: 'Areas of the market have become fully valued, and while you can still buy sensible businesses with reasonable growth, we don't think the returns on offer are nearly as attractive as they were six years ago.'
The problem is that, eventually, developed market central banks will raise interest rates. When that happens, the safer assets that are natural homes for many investors, such as government bonds, will likely become attractive again, potentially causing a mass exodus from riskier areas and leading to significant capital losses for those left behind.
Of course, analysts have been warning of impending doom for some time, but with the US Federal Reserve poised to raise interest rates in September this year, many believe now really might be the time for investors to revisit their portfolios.
Fixed-income investors are arguably the most vulnerable to an interest rate rise, as yields react almost immediately to a hike. This can lead to capital losses for existing investors stuck with more expensive, lower-yielding bonds, as new investors pile into cheaper and higher-paying notes.
This situation can be exacerbated by a lack of liquidity in secondary markets, leaving investors trapped in low-paying bonds due to a lack of buyers. This is the doomsday situation many commentators have been predicting for the high-yield bond space for some time, due to the withdrawal of the banks from bond markets post-2008.
There are also risks in equity income markets. John Ventre, head of multi-asset at Old Mutual Global Investors, says: 'Over the next six to nine months, we have to distinguish between things that are modestly yielding bond proxies in the equity income space and things that are cheap high-yielding stocks.
'As the US enters a rate-hiking cycle, bond proxies such as utilities and healthcare - anything you would describe as a cash cow - that are trading at high valuations, will be vulnerable in that kind of sell-off.' Essentially, as investors flee back to government bonds, those left holding these 'expensive, defensive' stocks could find themselves out of pocket.
At this point in the cycle, might it make more sense to focus on capital preservation and capital growth, rather than yield? Joe Le Jehan, multi-asset portfolio manager at Schroders, thinks so.
He says: 'The biggest risk for income investors now is that their total returns will be negative. If you are stretching for yield, you've got to think about the price you're being asked to pay. Yes, you might be getting paid 4 per cent, but if your capital falls 10 per cent as valuations tumble, that is a pretty poor investment.'
Coombs agrees. 'Given where we are,' he says, 'growth stocks are likely to continue to outperform over the next three to five years. A lot of bond proxies are not growing, and I think investors will start to focus on companies that are genuinely growing their bottom lines.
Both managers recognise that there are investors for whom income is not a choice but a necessity, most notably retirees who may rely on their investments to pay their day-to-day expenses. There are no easy answers for such investors. According to Coombs, Ventre and Le Jehan, they have little choice but to accept lower levels of income.
Coombs says: 'If they're buying stocks that pay out 90 per cent of their earnings, quite clearly those dividends are vulnerable if we see the cost of capital rise [as it does when interest rates are hiked]. So you might want to target a lower yield, say around the 3 per cent level, but one that is more predictable.'
This may hurt in the short term, but Le Jehan observes that protecting your capital leaves you with the means to buy back into income-bearing assets once yields become more favourable.
It's possible to draw down capital rather than target high-yielding assets for income. Many private investors forget they can take advantage of their £11,100 tax-free capital gains tax allowance in this respect. This may be a more tax-efficient way of generating an income rather than focusing on income-producing assets in the current environment.
However, as Ventre explains, this may cost investors dearly in the long term, particularly if their capital is not growing. 'There is an advantage in taking income versus just drawing down capital.
'If you rely on drawing down capital for income, it has a negative pound-cost averaging effect, so it makes a difference what price you sell at, whereas if you are taking a natural yield, you are never selling the asset, so it's not too important,' he says.
As ever, the answer to this conundrum may lie in a compromise. Taking inflation into account (assuming inflation will return to the BoE's target of 2 per cent from its current 0 per cent level), Coombs argues that a combination of modest capital growth and moderate income may provide the best solution for income-seekers in the short to medium term.
'If inflation is 1.5-2 per cent over the next two years, you need to make a real total return of 2 per cent and only distribute income over that. So why not try and generate that 2 per cent from capital growth and have a 3 per cent income yield? That would provide a better balance and a less volatile income stream [than a 5 per cent yield],' the manager argues.
Analysts, fund managers and journalists may have all been predicting rising interest rate calamity since the BoE floored its base rate in March 2009, but so far they have been wrong. In the face of the predicted Armageddon for fixed-income markets in 2014, UK index-linked gilts outperformed all other asset classes in the year. Moreover, markets continue to disbelieve the Fed and dismiss its rate rise projections.
That said, with the US economy growing at 2.2 per cent a year and unemployment falling fast, complacency may have set in. If that is the case, investors would do well to be prepared.
FUNDS TO FOIL THE YIELD TRAP
Mona Shah, co-manager, Rathbone Multi-Asset Portfolios
Artemis Global Income: Manager Jacob de Tusch-Lec is underweight in the US and overweight in Europe, differentiating the fund.
Pimco Global Dividend: The fund was one the first to tilt towards high-quality, economically sensitive companies. The team is very aware of valuations.
Edinburgh Investment Trust: Edinburgh is managed by the well-respected Mark Barnett. The fund yields 4 per cent and is trading at a 5 per cent discount.
John Ventre, head of multi-asset, at Old Mutual Global Investors
Schroder Income: This UK income fund takes a disciplined, often contrarian value approach to finding yield.
Wells Fargo Short Term High Yield: This short-term fund delivers yield without much of the downside risk inherent in longer-duration bond funds.
RARE Infrastructure Value: Rare is a well-diversified global infrastructure securities fund that, unlike most of its UK peers, does not trade at a premium.