Unlocking the best income opportunities

It may have been a long time coming, but income seekers have seldom had it so good. After the income famine of the past decade, investors now have myriad ways to generate a high and reliable income from their investments. While most investors will turn to large-cap equities, or government or corporate bonds, they shouldn’t overlook some of the other options available.

Within equities, income investors often limit their horizons to an uninspiring blend of energy, mining and financials. These may be steady and consistent, but they aren’t going to deliver exciting growth. Looking further down the market capitalisation spectrum can be a better option for longer-term growth in income and capital. It is worth noting that the FTSE Small Cap index now yields more than the FTSE 100*.

Simon Murphy, manager of the VT Tyndall Unconstrained UK Income fund, for example, has a mid-cap focus: “The UK has always been a good income market. But 20 stocks in the UK market, every year, provide 60-65% of the income. I think you can do better, and be a bit different. By focusing on the mid-cap, we diversify our income away from those top 20 companies.”

It is a similar picture in European markets, with small-caps offering comparable dividends to large-caps*. The Montanaro European Income fund delves into this part of the market. Manager Alex Magni says it looks particularly appealing at the moment: “We continue to believe that the small-cap space looks more attractive than it has for some time, relative to recent history. After a generally good earnings season, valuations are compelling, particularly when compared with large-caps. European small-caps are trading on a 4% discount to large-caps, higher even than during the Global Financial Crisis of 2008.

“In addition, while the market undoubtedly got ahead of itself in its anticipation of interest rate cuts, inflationary pressures continue to be easing, benefitting two things: the supply chain issues that some of our companies have been exposed to and destocking.**” He believes this will be good for smaller companies.

Another option to consider would be a US equity income fund. Investors have generally looked to the UK market for its AI and technology prowess, but it has some credentials as an income market as well. This can also be a useful way to diversify US exposure after a strong run for growth stocks. The JPM US Equity Income fund, for example, is a good defensive option with a yield of 2.3%***.

Asian income is also overlooked and yet can be a neat way to combine capital growth and dividend strength. Income tends to be more diverse in Asia, with the region’s technology giants such as Tencent, TSMC or Samsung showing a strong dividend track record. Investors have been deterred from investing in Asia by the weakness in Chinese markets, but Asian equity income managers tend to be lightly invested in China anyway (because the companies there don’t tend to be big dividend players), and there has also been some revival in the Chinese market since the start of the year. We like the Schroder Oriental Income trust for income exposure in the region.

What about fixed income markets?

It is easy to get an income from a conventional government or corporate bond fund. A 10-year gilt has a yield of 4%****, well ahead of inflation at 2%. Many corporate bond funds now pay an income of 6-7%. These yields come with relatively low risks and will be the bedrock of an income portfolio.

That said, investors don’t have to go that much further up the risk scale to get a significantly higher income. Developed markets may be deferring rate cuts, but emerging markets are well under way with their rate-cutting cycle. For example, Brazilian rates have dropped from 13.75% to 10.5%, over the past 12 months^. That means investors are getting an attractive yield, but also some capital appreciation.

Dickie Hodges, manager of the Nomura Global Dynamic Bond fund, tells us more about opportunities in the South African bond market in a recent interview.

BlueBay Emerging Market Unconstrained Bond fund manager Polina Kurdyavko thinks emerging markets are worth another look: “The biggest improvement in emerging markets over the last decade has been much more orthodox monetary policy, which is why emerging market central banks started to hike almost two years before their developed market counterparts and have been successful in tackling inflation.

“Furthermore, despite the fact that we’ve had Covid and big economic shocks, emerging market economies have spent less of their fiscal buffers in order to protect the economy. Therefore, generally, we’ve seen healthier balance sheets, both from a fiscal perspective and more orthodox monetary policy.” In other words, investors can pocket the yield without some of the risks that have traditionally been associated with emerging markets. This may be a better option than high yield bonds, where spreads over government bonds are very low and leave little room for a deterioration in the economic climate.

GAM Star Credit Opportunities might be another ‘alternative’ choice. Managed by Anthony Smouha with a distribution yield of 4.6%***, the fund invests in the junior or subordinated debt of higher quality companies to capture higher yields without taking significant risks.

Rhys Davies, manager of the Invesco Bond Income Plus Trust, covers the nuances of subordinated bonds, corporate hybrids and diversification on a recent episode of the Investing on the go podcast.

Any other options for investors?

There are also a few left-field choices elsewhere in the market. Investors might want to dip a toe back into commercial property funds, for example. There has been a small recovery in higher quality commercial property after a very difficult period for the asset class. It appears the sector may have finally absorbed the impact of higher interest rates and home working, with funds such as TR Property and CT European Real Estate Securities bouncing back significantly in recent months. Yields are still relatively high in the sector, and the worst may be over.

There are also income options for those who’d rather leave selection to the experts. Ninety One Diversified Income, Jupiter Merlin Income Portfolio or M&G Episode Income combine conventional income options with some of these more unusual income sources and can give a diversified income portfolio in a single package. Either way, investors now have abundant choice – it’s a nice problem to have.

*Source: Morningstar, 6 July 2024

**Source: Montanaro, Q1 2024 commentary

***Source: fund factsheet, 31 May 2024

****Source: MarketWatch, 16 July 2024

^Source: Trading Economics, July 2024