The essentials for your income search

• QuotedData
• Matthew Read

If you look across the investment companies’ space, it is clear there is still strong demand for trusts that can provide investors with an attractive level of income which is reliable and, ideally, has some degree of both inflation protection and capital preservation. Despite the environment of higher interest rates that has prevailed over the last couple of years, trusts that can offer investors a decent stable yield have generally traded close to asset value, or at a sensible premium, and have been able to issue stock and grow – CQS New City High Yield is one example that quickly comes to mind.

Given this, we often get asked questions about what factors investors need to think about if they are looking for income from investment companies. With the end of the year approaching, and some investors making plans for 2025, it seemed a good time to look at the more common income-related questions we get asked and show some of the opportunities that are on offer. For those that want to know more about income in general, our weekly show included a special panel discussion looking at income.

What constitutes a good yield on a fund?

This really depends on the yield of the underlying assets. Some funds invest in assets that may have limited or no prospect of capital growth, and investors will require a higher yield to compensate for that. Many fixed income investments fall into this category as the bulk of their returns comes in the form of income. At the other end of the spectrum there are funds focused on equity investments in businesses that are at an earlier stage in their life cycle. These companies tend to reinvest the bulk, if not all of their profits, back in the businesses to fund growth. As a consequence, these businesses will throw off little or no cash to their investors, whose returns will come in the form of capital growth rather than income, and yields will be low or non-existent. Growth capital funds such as Chrysalis are an obvious example. Then there is everything else in between.

Another important consideration is that some underlying assets are riskier than others. Risk can take many forms such as greater price volatility, higher default risk, greater income variability or greater regulatory risk. Such investments will need to offer an additional return to compensate investors for this additional risk. This may come in the form of higher potential capital growth, or it may come in the form of a higher yield. One way of illustrating this is to compare the yields on investment grade and high yield bonds. The latter is deemed riskier, and investors require a higher yield as a result.

Beware the value trap!

It is often said that some stocks are cheap for good reasons, but their low share prices can amplify their yields making them appear attractive. Value traps, as they are frequently called, may look cheap but, if a business or asset is fundamentally flawed, its price can continually spiral downwards as its profitability or returns are eroded. In the extreme, investors may lose all of their investment. This is why, when it comes to yield, biggest is not always necessarily the best when selecting income investments, and it is important to look at other factors as well.

The importance of diversification

Diversification is important in any portfolio but, if deriving a certain level of income is key to your investment objectives, it is important not to be overly exposed to any particular type of income stream. It also follows that, if income is important, capital preservation is also likely to be important for the simple reason that, if capital is lost, it is no longer be able to earn an income. It is therefore important to spread this risk and have a mix of exposures, with different asset types and geographies (this can spread currency risk, political risk, and regulatory risk).

We explore a range of funds from different sectors below and we would suggest investors do not focus on just one or two but should spread their risk more widely. It is worth remembering that funds that are well diversified, or perhaps offer an exposure that is otherwise difficult to access and so may act as a good diversifier, may experience stronger demand, and offer a lower yield. The compensation is that they should either offer more stable income themselves or serve to bring greater stability to an investors’ overall portfolio.

How important is income sustainability?

The sustainability of income is another hot topic for income investors and the reality is that its importance will depend on an individual’s own personal circumstances. For example, someone who is further on in their retirement will likely prefer lower risk, or less volatile, investments that offer greater certainty of income at the expense of capital growth or possibly even eroding their capital. Others who wish to derive income for a long time to come, will be much keener to see that income growing as well. This is why investors who have a longer time horizon will tend to have greater exposure to equities and less to fixed income, and vice versa.

Related to this, we are often asked, is it okay to pay some income out of capital or should it just be from the revenue account or even just the current year’s revenue? There has been a lot of debate around these topics and, while there are strong views on the differing sides, a lot of it comes down to personal preferences. However, we would argue that if investors are able to rely on income, payments need to be sustainable over the longer-term.

If you are investing in a fund that owns income generating assets, it makes sense to us that, for the majority of the time, dividends should be covered and, ideally, such funds should also be gradually adding to their revenue reserves, allowing them to draw on these to maintain the dividend when there is a down year. This is a key advantage of the closed-ended structure, and we see little point in income funds having revenue reserves if there is no intention to draw on them in years when there has been a shock to income.

However, if funds are invested in income generating assets, yet are continually drawing on their revenue reserves, this suggests that they are over-distributing and running down their capital. As noted above, this may suit some investors but not all. Our personal preference is for funds not to over-distribute in this way. However, we think there is one exception that investors should be aware of. There are a number of funds that perhaps derive some income but have also been good at generating capital growth too and, in a world that values income, they convert some of that capital growth to income to make themselves more attractive to investors.

Once again, this comes down to personal preferences, but we think that, in such instances, if the dividend is well covered by the combination of income and capital returns, this approach makes more sense. Patria Private Equity (PPET) is an example of a fund that has done this well. It has a natural yield of around 2-2.5% on its portfolio (contrary to popular belief, a lot of private equity is cash generative) but amplifies this to around 4% by drawing on its capital profits. It has plenty of room to do this having generated annualised NAV total returns of 14.5% over the past 10 years.

Global funds

In the current market environment, we think a global equity strategy should offer a yield of around 4% (the median for the AIC’s global equity income sector is just over 4% at the time of writing) and would argue that it is difficult for a trust to position itself as an income vehicle if its yield is below 3%.

Another popular trust that is issuing a lot of stock is JPMorgan Global Growth & Income (JGGI). It sets a target dividend each financial year equal to at least 4.0% of the NAV of the company as at the end of the preceding financial year, topping up the income it generates from capital. JGGI has performed strongly (it ranks in first place in its sector over five years with an annualised NAV total return of 15.7% and is also the top trust over 10 years with an annualised NAV total return of 13.9%) and trades at modest premium (1.3% at the time of writing versus a median discount for the sector of 8.3%) as a result.