The stock and bond market sell-off means that investors can snap up inflation-busting yields – but high income can come with high risk, explains Sam Benstead.
The rising cost of living means that it has never been so important to turn to an investment portfolio for extra income.
Fortunately for investors, lower stock and bond prices mean that yields have risen, and some funds and shares even offer yearly income payments of around 10%.
But, it is important to bear in mind that high yields suggest higher risk because investors demand extra compensation for owning less secure assets and income streams.
We look at the highest-yielding fund and investment trust sectors and assess whether the income really is too good to be true.
Emerging market bonds
One of the highest-yielding sectors is emerging market bonds. Bonds issued by less developed nations, such as Mexico or Indonesia, are considered more risky by investors as there is a higher likelihood of default, as well as risk that currency will fall in value.
However, with investors therefore demanding a premium to lend to such countries, yields are higher than in safer corporate or developed government market bonds.
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The highest-yielding emerging market bond funds (sourced from FE FundInfo in October 2022), are Invesco Global Emerging Markets Bond (10% yield) and NinetyOne Emerging Markets Blended Debt (8%). M&G Emerging Markets Bond, a member of interactive investor’s Super 60 list of investment ideas, yields 6.5%.
These funds own bonds issued from governments that include Brazil, Mexico, Malaysia, Peru and China.
Dzmitry Lipski, head of funds research at interactive investor, says: “Emerging markets bonds can help generate an attractive yield and their low correlation to other asset classes should offer good diversification benefits to an investor’s portfolio.
“Emerging market debt has been under pressure over the last year and sold off on the back of elevated inflation pressures and the hawkish response from central banks and subsequent strengthening US dollar. In addition, Russia’s invasion of Ukraine has exacerbated the sell-off in emerging market debt causing significant outflows and underperformance versus other fixed-income markets.”
But he adds that the high returns compared with safer, developed market bonds means that valuations are starting to look attractive, making it a good buying opportunity for long-term investors.
Lipski adds: “As there are likely to be clear winners and losers in this market, active managers employing a more flexible approach and accurately managing risk, should be a better choice for investors.”
Lending money directly to companies can bring higher yields than in traditional bond markets, but there can be more risk involved.
Key trusts in the “direct lending”, “structured finance” and “loans and bonds” space are: VPC Specialty Lending Investments (10.5% yield); Honeycomb Pollen Street (10.5%); Riverstone Credit Opportunities Income (9.2%); GCP Asset Backed Income (9%) and TwentyFour Select Monthly Income (9.5%).
Shares in these trusts have fallen this year amid a wider downturn in stock markets, but also due to investor concerns that a recession and inflation will cause low-quality borrowers to default on their debt.
James Carthew, head of investment company research at QuotedData, said: “Investors need to understand what they are investing in, as some of these funds can be very complicated, and high yields come with extra risk.”
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Carthew says that structured lending funds are exposed to the riskiest “tranche”, or part of a loan, which makes them the first to be punished if there is a default. An advantage, however, he says, is that a lot of the debt is floating rate, meaning that interest payments rise when interest rates do.
Leasing funds are another high-yielding sector, according to Carthew, but he says that aircraft leasing investment trusts, such as Doric Nimrod Air and Amedeo Air Four Plus, with yields of 20% and 16%, are too good to be true.
The big risk, Carthew argues, is that the value of their fleet of planes has dropped, and high oil prices and travel disruption could affect their businesses.
But Carthew says that investors did not have to delve into the more niche areas of the investment trust market to get a top-tier income. Straightforward equity trusts can also do that, such as BlackRock World Mining on a 7.5% yield and arbdn Equity Income Trust (7.4%).
He said: “Investors can get some chunky yields without having to go into hard-to-understand areas, which may be very vulnerable to a recession and rising interest rates.”
Another way of getting a high income is to bend the rules slightly, so that financial contracts known as derivatives can be used to trade share price gains for income.
“Enhanced income” funds in the UK Equity income sector can yield as much as 8%. This includes Premier Miton Optimum Income (8% yield); Schroder Income Maximiser (7%); Fidelity Enhanced Income (6.5%) and BNY Mellon Equity Income Booster (6.3%).
Global enhanced income funds can yield as much as 11%. These include UBS Global Enhanced Equity Income Sustainable (11%); Premier Miton Global Sustainable Optimum Income (6.7%); abrdn Global Dynamic Dividend (6.6%) and Fidelity Global Enhanced Income (5.7%).
However, Neil Denman, fund manager of Sarasin Global Dividend, which is not an “enhanced income” fund, says investors should be careful.
“Be wary of enhanced income funds – how will they work in stressed scenarios? What about regulation risk?
“Turning capital into income, which avoids taxation, may become a target for regulators, so taxes may go up on these types of funds and enhanced income may not be good place to be,” he said.
The riskier end of the bond market is high yield, or “junk” bonds. By buying the bonds of lower-rated companies, investors get a higher return.
The risk though, similar to the specialist lending sectors, is that companies with lower credit ratings are more vulnerable to changes in the economy, with a recession and higher borrowing costs as interest rates rise potentially leading to defaults.
Deutsche Bank says that 2023 could bring about the end of the ultra-low default world. Jim Reid, of the firm, said: “First, we will likely have a cyclical US recession to address in 2023, and after that, a risk of the reversal of trends that have made the last 20 years so subdued for defaults.
“We've been convinced the ultra-low default world would hold for as far as the eye can see. However, this year we speculate that things might become more difficult for corporates in the years ahead. Our view has long been that inflation would rise this decade for structural reasons. The pandemic and the aftermath have accelerated and exaggerated this.”
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Mike Della Vedova, a high-yield bond portfolio manager at T Rowe Price, says that while stock market fund returns are primarily driven by economic growth, high-yield bond funds are mainly about credit risk.
The key questions for investors are whether they will receive their coupons and their principal back and how likely the firm is to default, he says.
Della Vedova adds: “Because the coupons on high-yield bonds contribute a much higher proportion of total returns than dividends contribute for stock returns, the income profile is much smoother. For investors willing to take on a bit of risk in their portfolios, high-yield bonds may therefore be a smart choice in the period ahead.”
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