Ben Willis of Bristol-based Whitechurch Securities, outlines using a blended approach to asset allocation
The times they are a-changin’ for income seekers as we move into a new phase in markets. Even though we are still living with emergency interest rates, the age of loose monetary policy is coming to an end. With relatively stable global economic growth and higher inflation numbers, interest rates are trending higher. What does this all mean for income investors?
Historically low interest rates have meant that even the most cautious income investor has been forced to take on more and more risk in order to meet their income requirements. This demand for income has been a key driver in the bull market in bond and equity markets for the last nine years.
Looking ahead, bonds are under pressure due to inflation and the prospect of rising interest rates, whilst recent stockmarket declines are a timely reminder that equities are risk assets and they do not always go up! Against this precarious backdrop, I favour using a broadly diversified approach to constructing an income portfolio, including the use of a blend of yielding assets such as bonds, equities and commercial property.
Blending different approaches for diversification
UK companies have traditionally delivered strong of dividend yields, and so the core of my income portfolio would be invested into a blend of complementary UK equity income funds. I’d spread the exposure here, ranging from the more defensive, large-cap focused funds through to funds investing in dividend paying mid and small cap UK companies.
To further diversify the portfolio income stream, sourcing dividend income from overseas is sensible, utilising a number of globally-focused, equity income holdings. This could be done either by using global income funds or by investing in specific regional market funds – or a combination of both of course. Thematic funds could also play a part. As an example of this, within the current inflation / interest rate-focused environment, I would favour exposure to income-producing Financial equities, which have tended to thrive in this scenario in the past.
Fixed interest looks overpriced
After years of delivering equity-type performance, in my view fixed interest markets are looking overpriced, with bond yields in several areas now standing at historical lows. Even though I am generally negative on the outlook for fixed interest markets, the asset class does still have an integral role to play within a balanced income- focused portfolio due to the diversification attributes and yield that it provides. Drilling down a little, I would avoid UK conventional gilts, believing that these are looking overpriced with an asymmetrical risk profile (i.e. too much downside risk). My preference would be for investment using strategic bond fund managers who have a proven track record of unlocking value across fixed interest markets.
Don’t forget bricks and mortar
Finally, I would allocate some of my portfolio to UK commercial property funds. Although we witnessed a liquidity crisis in the asset class following the Brexit vote, this was largely due to investors reacting to negative sentiment. Commercial property returns are loosely correlated to the overall health of the UK economy and this has remained remarkably robust in the face of the Brexit scenario. As a result, property is once again delivering consistent income-driven returns for investors, which are relatively attractive when compared to gilts. In addition, property aids diversification within the overall portfolio as it is uncorrelated to both equity and bond markets.
Pick and mix
Of course, how much you decide to mix and match the different types of income-producing assets mentioned will depend on how much risk you can tolerate and what level of income you need to generate for the portfolio or client objectives you are seeking to fulfil. However, holding a blend of these assets is a tried and tested method of delivering a growing income stream together with producing an element of capital growth over the long-term.