The income challenge in a higher inflation world

Structurally lower interest rates have created a long-term headwind for income investors, but today they have a new challenge: inflation. With price rising, charity investors need to be more careful that they preserve the real long-term value of their income.

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Nick Murphy
Published: 29 Jun 2021 Updated: 13 Apr 2023
Reporting 426028597

The search for yield

It will not be news for many trustees that finding income is a challenge. Structurally lower interest rates have created a long-term headwind, lowering the returns expected from bonds. Equity income had proved a useful alternative but suffered significantly during the pandemic as companies were forced to cut dividends in the face of uncertain earnings.

This might have been bad enough, but now income investors now face a new challenge – inflation. For some years inflation has been largely benign, operating at or near the Bank of England’s target rate of 2% (1). The only brief spike in the last three decades was as the world emerged from the global financial crisis in 2011.

Today, inflationary pressures appear to be mounting. Pent-up demand, government spending and supply bottlenecks have conspired to push prices higher. This has been most notable in the US, where CPI data showed rises of 5.3% and 5.4% in August and September respectively (2). However, it is also happening in the UK and Europe.

A final consideration for charity trustees is sustainability of income. Investors need to ensure that the businesses in which they invest can thrive over the longer-term. That means ensuring that businesses are managing environmental, social and governance risks.

There can be little doubt that generating an income has become more complex and trustees (and those who invest on their behalf) will have to work harder in the years ahead. There is not one, but multiple answers to the problem.

Equity income

Equity income has had a hard year, particularly in the UK. The UK market has suffered from a reliance on cyclical areas such as energy and financials, but it also became clear that many companies had been overpaying dividends before the crisis. While the UK market looks in better shape today, with dividends re-set at lower levels and earnings improving, the pandemic should still have provided a reminder of the importance of drawing dividends from across the globe.

Adding dividend-paying companies from outside the UK brings in a greater diversity of sectors and means a portfolio is not reliant solely on the ‘old economy’ industries that dominate in the FTSE 100, where dividends may be high, but long-term growth is low.

It is also important to prioritise dividend growth. Companies able to grow dividends sustainably must do so from higher earnings. On a total return basis, higher dividend payers haven’t kept pace with higher dividend growth companies over time. In a climate of higher inflation, this gap may become more pronounced.

Within these parameters, the prospects for equity income investments look relatively strong. Dividend payments are resuming across the world, valuations in some areas remain low and many companies have moved to more realistic payout ratios. This will still form the bedrock of most income portfolios.

Total return

We have also seen many charities switch to a total return approach, where both the income and the capital gains can be treated as incoming resources. The trustees then have discretion on how much of the total is transferred to the income funds of the charity. Any incoming resources not transferred in an individual year can be reserved for future years.

This approach has some notable advantages: it provides an investment manager with greater flexibility to manage the portfolio in line with the charity’s risk parameters and objectives. Rather than being forced to pick between a smaller and smaller range of income-generative assets, the investment manager can select the investments to maximise the overall return, consistent with the investment policy and the approach to risk. They can also bring in assets with a greater focus on quality and sustainable growth.

It may also provide the investment manager with more options to protect against inflation. It guards against a focus on income at all costs, which may leave charities with higher portfolio risk than they would like. A total return approach allows the investment manager to buy assets with a lower yield and - more importantly - a lower risk profile. This more flexible investment approach increases diversification in both asset and sector selection.

Alternative income

There are a range of alternative income sources, from battery technology, to infrastructure, to social housing. These often have the twin advantages of lower correlation to conventional equity and bond markets, but also paying a high and inflation-adjusted yield. However, they need to be employed with caution. In periods of market stress they can be illiquid, which pushes up their correlation to equities. Also, a lot of capital has been directed at alternative income options over the past few years, which has pushed prices higher. Nevertheless, used judiciously, they still have a role in an income portfolio.

A final note on fixed income

Fixed income has lost several of its key qualities: in many cases, bonds no longer pay a reasonable income, their returns are negative once adjusted for inflation and their value as a risk-off diversifier to equities is under question. That said, it is important not to dismiss the role of fixed income in a portfolio entirely. Government bonds are still an important source of liquidity and they will still hold their value better in periods of volatility. Inflation-linked bonds, although expensive, still provide protection from unexpected increases in inflation. Equally, it is still possible to get higher income, looking at corporate bonds, less liquid but still high-quality credits in specialist vehicles and in emerging market bonds in countries likely to have strong currencies.

The key is that there is not one solution to the income dilemma for charities today: diversification is the only free lunch. It is only by employing a blend of strategies that investors can secure a reliable, inflation-adjusted income stream that is sustainable for the longer-term.

References:

1 https://www.ons.gov.uk/economy/inflationandpriceindices
2 Refinitiv data as at 4 November 2021

 

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

RISK WARNING
Capital at risk. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. Past performance is not a guide to future performance. Further information is available in the Key Investor Information Document (KIID), the risk section of the Fund’s prospectus and the Fund Factsheet. Please read the KIID before making any investment decision.

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Disclaimer

This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.