John Husselbee

How to find real yield in 2021

John Husselbee

With lingering concerns remaining about equity dividends, which halved in 2020, plus growing risk and generally lower yields available from bonds, income seeking investors are understandably wondering about options for 2021 and beyond.

To deal with the equity point first, there are suggestions we may not see UK dividends return to pre-Covid levels until 2025 or later, with figures from Link Group revealing the £61.9 billion in distributions from UK plc last year was the lowest annual total since 2011. Two-thirds of listed firms either cancelled or cut dividends in the last nine months of 2020, with the make-up of the UK market leaving it harder hit than other countries as most of the payout comes from a handful of large oil, mining and banking companies. Income seekers can obviously look to overseas equities but broadly speaking, there is a clear need for more diversified sources of yield.

Diversification is vital throughout the economic cycle, whether building portfolios for income or not, and this is clear from our position on the other traditional yield-providing asset class. Broadly speaking, we have been bearish on fixed income for at least four years (and with interest rates unlikely to rise for the foreseeable future, yields look rangebound at current low levels) but have maintained exposure as zero weighting any asset class negates the long-term benefits of diversification. Bonds continue to meet four roles in our portfolios: providing some income, capital preservation, inflation protection and diversification from equities.

As with equities, we encourage a global approach to fixed income, with opportunities beyond the sterling government and corporate bond markets. Strategic bond funds, with flexibility on duration and credit risk, are one option but we tend to avoid these as they are dynamic in their positioning by nature and therefore difficult to fit within our target risk portfolios. At present, given worsening conditions for bonds overall, we are avoiding market beta and focusing on areas where there is more alpha available: we are overweight high yield bonds (which offer a more attractive risk/return and greater yield than investment grade credit), hold some emerging market debt, and recently increased our position in index-linked bonds to protect against any rise in inflation. We are not expecting a huge spike in prices but, given the fact central banks around the world are prepared to accept higher inflation as a corollary of recovery from Covid-19, index-linked exposure is a sensible holding.

Beyond these standard areas, we also press the case for real assets as a solid income option, again bringing further diversification to a portfolio. ‘Real’ here means tangible assets such as buildings, toll roads, solar or wind farms or commodities such as energy, livestock or grains, which derive value from their availability and usability by consumers and businesses.

A unique feature of infrastructure is the fact that a significant amount of revenues benefit from stable and predictable demand, making these assets more economically resilient and less affected by the business cycle. These defensive qualities are supported by long-term inflation-linked contracted cashflow streams, which are typically government backed. Given these sectors often provide critical services, used for social or environmental purposes, they also tend to enjoy accommodative government policy (through tariffs and grants) and regulation.

Looking at some of the examples within our Liontrust Diversified Real Assets Fund (DRAF), core infrastructure focuses on essential assets providing support for communities, such as schools and hospitals, and benefits from the kind of state-backed cashflows outlined above. We hold HICL, for example, a fund investing in equity stakes of social infrastructure projects based primarily in the UK and owning 118 assets across a range of sectors. The fund aims to produce long-term stable income and has a dividend yield of around 5%.

Renewables are another branch of infrastructure. But, while they also benefit from long-term contractual cashflows, these are a combination of government subsidies and revenues from selling electricity to power companies and that element of demand in the latter introduces an element of economic risk. To compensate for this, dividend yields available are often slightly higher.

We always have to consider the challenges of any asset class as well as the opportunities, and beyond the complexity of certain areas, the main issues with many real assets are access and liquidity – and both have dogged property over recent years. On the surface, this is another real asset option to diversify income exposure, benefiting from long-dated rental income and protection against inflation – often enjoying upward-only rent reviews linked to the Consumer or Retail Price Index (CPI or RPI – with yields also tending to offer an attractive spread over government bonds.

Given nuances within the sector, however, and the liquidity concerns surrounding open-ended property funds, it is important to have an active and well-diversified approach to the asset class. With open-ended funds, issues have come from the dichotomy between the retail market’s need for daily pricing and the liquidity profile of what remains an illiquid asset class. A number of larger direct property funds have been forced to suspend trading as a result of redemptions in recent years, which reignites questions around this asset’s suitability as a retail investment.

While we wait for managers of open-ended property funds, in conjunction with the regulator, to find a solution, there are other ways to access the asset class, including closed-ended Reits and investment trusts. We believe these vehicles are more transparent, giving greater access to, and understanding of, the underlying assets. The universe also allows us to access more specialist property managers who focus on subsectors such as healthcare, logistics, offshore wind, battery storage and digital infrastructure.

In contrast, most open-ended funds continue to have exposure to commercial property – offices, retail, residential and industrial – and these areas face considerable challenges in the post-Covid environment. The underlying quality and resilience of the cashflows from Reits in more specialist subsectors showed their strength in 2020, delivering attractive yields above 5% while the broader market slashed or suspended dividends.

As the DRAF portfolio shows, there are many options for income beyond traditional equities and bonds and we continue to believe expanding your sources of yield is a sensible approach given current constraints on both these asset classes.

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Friday, January 29, 2021, 5:43 PM