Alternative ways for income investors to find high yield

With many income investors overexposed to equities, Tom Bailey rounds up a range of ways to diversify your portfolio.

There has been a marked decline in investor bullishness over the past few months. The US market roared ahead, but global indices from Europe to Asia Pacific have stumbled. Growth has been slower and economic indicators across continents have been disappointing.

At the same time, the world economy has faced new headwinds as the US and China wage trade war. Moreover, central banks around the world (aside from Europe) raised interest rates – and more tightening is on the horizon – a telltale sign of the end of a market cycle.

The whole trend culminated in October's global market correction. It's not clear whether this is the end of the bull run, but many investors have been tweaking their portfolios in anticipation of more volatility to come.

Robin Geffen, chief executive and founder of Neptune Investment Management, says:

"As the bull market matures, people start scrambling around to diversify their way out of it."

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What does this mean for income investors in particular? Investors looking to both preserve their capital and maintain stable and secure income should be thinking about diversifying.

Ed Keon, chief investment strategist at QMA, says "diversification is important for all investors", but especially important late in a cycle when market drawdowns are expected imminently.

The need for diversification is made more acute by the likelihood that many income investors, thanks to the historically long bull market, are overexposed to equities. Ed Park, investment director at wealth manager Brooks Macdonald, says:

"Over the past few years of the bull market, a portfolio focused on global equities has typically performed very strongly, and attempts at diversification have tended to hold back returns rather than maximise client outcomes."

Bonds won't do

The traditional way to protect against a downturn is through investing in government bonds, which have historically gained value when equity markets have stumbled and economies weakened. That, however, is no longer an adequate form of diversification, for a number of reasons.

"Central banks have intervened extensively in government bond markets over the past 10 years," explains Alex Shingler, a portfolio manager in BlackRock's multi-asset strategies income team. "As a result, bond prices are potentially distorted in a way that makes them less useful diversifiers in the next market downturn." They tend to move more in sync with equity prices.

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Investors also have to contend with the fact that we are returning to a more inflationary world, following decades of low inflation, says James Dowey, chief economist and investment officer at Neptune.

This means the historical negative correlation between stocks and bonds no longer applies, again making bonds less useful as a diversifier. What's more, following a decade of ultralow interest rates, central banks are raising rates, which also hurts returns from bonds. Thus, argues Shingler:

"Income investors today need to look beyond government bonds."

Look for yield elsewhere

However, while there has been an explosion of interest in so-called alternative assets – investment options that are not equities or bonds – each appears to come with downsides as well as upsides for income investors.

David Thomson, chief investment officer at VWM Wealth Planning, suggests income investors consider property. This asset "generally provides a good income and is normally a relatively stable investment", he says.

But investors should be cautious of the risks associated with property when markets start to tumble.

John Husselbee, head of multi-asset at Lionstrust, says:

"The diversification benefits of direct property and a different source of yield are attractions, but these attractions have been diluted and undermined by the want of daily dealing."

This has presented problems for property focused open-ended funds, which struggle to offload their assets to give investors pulling out of funds their money back (as property cannot be sold quickly and may have to be sold very cheaply). This can result in trading being suspended, as happened after the 2016 Brexit referendum.

Funds have taken steps to address this liquidity problem, by including more cash or property-focused securities in their portfolios, for example. Husselbee says:

"Perhaps the closed-ended market [investment trusts or REITs] provides the answer. A trust's premium/discount mechanism [which forces its share price down, avoiding the need for managers to sell assets] deals adequately with the challenges of daily liquidity, particularly in larger investment trusts."

However, not everyone is positive about property as a diversifier. Geffen says property may be the worst option. He warns that for most people nearing or in retirement, property – in the shape of their home – is already their largest asset.

Peer-to-peer lending has grown in popularity recently and will be familiar to many income investors. Investors can access the market online through P2P platforms. What's more, they can invest in P2P opportunities tax-efficiently through the innovative finance ISA (IFISA). This, however, presents some risk. Investors could lose their capital should a borrower default, as loans are not covered by the Financial Services Compensation Scheme.

An alternative way to invest in P2P lending is through dedicated investment trusts such as P2P Global Investments. However, many financial professionals urge caution. Geffen says:

"It is hard to see P2P lending escaping higher default rates [among borrowers] as interest rates continue to rise." Thomson also urges investors to be wary "and limit their exposure to a relatively modest portion of their overall portfolio".

Infrastructure: a halfway house

Another popular alternative asset class is infrastructure. Thomson says: "Infrastructure has been touted as a possible solution, as it is a kind of halfway house between equities and bonds." Park says: "Typically, cashflows in this sector are attractive, as they are secured by physical assets and/or high-quality counterparties."

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Ben Yearsley, director of Shore Financial Planning, points out that investments in this sector are also often inflation-linked: equity-focused infrastructure fund HICL Infrastructure, for example, has proved very popular with investors. Its revenue is 80% inflation-linked.

Again, there are reasons to be cautious, however. Geffen argues that infrastructure is not in fact a good diversifier:

"The danger of investing in infrastructure is that global interest rates are rising, so these capital-intensive projects are likely to see lower returns."

Similarly, Park warns: "As yielding investments, the these securities" prices will be correlated with interest rate movements, so there is bond-like risk in the asset class.’ He notes that infrastructure also carries an element of political risk.

A variation on this theme is infrastructure debt funds such as Sequoia Economic Infrastructure, a £900 million investment trust that provides loans to the infrastructure sector, stepping in to fill the finance shortfall left by banks in the wake of the 2018 financial crisis.

The trust looks across developed economies for large 'monopoly' projects or projects with high barriers to entry. It pays a yield of at least 6% (currently more than 8%) and offers modest net asset value growth.

It has proved popular with retail investors. Portfolio manager Steve Cook says it has a low correlation with equity movements and there is little political risk associated with the infrastructure projects the trust targets. He adds: "Most of the infrastructure projects we lend to are pretty essential."

Of course, risks remain. Adrian Lowcock, head of personal investing at Willis Owen, says: "The big risk in the UK is political risk, as the Labour Party has said it would seek to nationalise some PPP initiatives and infrastructure, including the water companies. The government could then repay the debt earlier, which would be negative for any debt trading above par, as investors would get back less than the current market value of that debt."

No perfect solution

No alternative asset class is risk-free. Any of them could fail to hold up in the current economic climate. However, while many alternative assets have clear downsides, investors can use them to construct portfolios, based on their investment needs, that build in some protection.

Keon says the right portfolio allocation "will be determined by the level of wealth and the projected income need". He notes that those with substantial assets may want to take the ultra-low-risk option of cash and bonds, while for those needing income and having more risk tolerance, "some percentage of the portfolio spread across alternative asset classes might make sense". Thomson advises an allocation of 3% in both P2P and infrastructure.

Rupert Thompson, head of research at KW Wealth, argues that income investors may have to accept lower returns to get a relatively safe income-producing portfolio.

"Government bonds and – perhaps – high-grade corporate bonds are likely to be the only income-producing asset classes to offer protection in the next downturn," he says.

Investors at the end of the cycle should make sure they have sizeable allocations to these, even though this means accepting significantly lower income.

Cash is ultimate safety net for nervous investors

Ultimately, says Robin Geffen, there is little hope of diversifying enough to sustain income levels in a falling market.

He adds:

"In the end, all asset classes are currently highly correlated with equities, so they suffer in falling markets."

 However, he points out:

"At the end of the bull market, we are far more likely to see a capital loss than a considerable fall in the underlying dividends paid by companies."

That being the case, should nervous investors simply put a larger amount of their portfolio into cash? If they fear a capital loss, they can always set aside sufficient cash to meet future needs.

David Thomson suggests an estimated six to 12 months of income to ride out a storm while giving the capital value of a portfolio time to recover again.

He adds: While this may act as a drag on longer-term investment performance, investors can raise cash from the most appropriate source according to circumstances.

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