Interactive Investor

Benstead on Bonds: are bonds now the only game in town for income?

22nd May 2023 14:25

by Sam Benstead from interactive investor

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Yields have risen as rates have, but just relying just on bonds for income would be a risky approach, writes Sam Benstead.

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Investors, via platforms like ours, have the world at their fingertips. With the tap of a button on their phone they can move their money across different funds, investment trusts, shares and bonds, all on similar terms to professional investors.

This means that when the investment world changes, investors can easily adapt to make their money work as hard as possible for them.

Nowhere is adapting to new market conditions more important than income investing, where the returns generated by a portfolio can be used to fund living expenses.

The biggest story of the past year has been interest rates rising, which has prompted a big sell-off in bonds, therefore pushing up their yields.

Bonds were typically a core asset class for income investors, but with interest rates settling around zero in the UK from 2009 to 2022, yields were measly, and the main draw of bonds was their capital gains.

Instead of buying bonds for income – which yielded nothing at the safest end and only a couple of percent in higher risk sectors – investors poured money into the “alternatives” sector, generally made up of investment trusts that owned so-called “real assets”.

This included renewable energy infrastructure and regular infrastructure investment trusts, which generated revenue from selling power to the grid or owning physical assets like toll roads or train lines, as well as property investment trusts that make money renting out buildings to businesses and the public.

These types of investments could make investors 5% a year in income – way above what bonds paid you, and in some cases, such as emerging market or high yield bonds, with much less risk.

How do bonds compare with other income sources today?

Calculations from Winterflood, a stockbroker, show that the average yield in the renewable energy infrastructure sector is now 5.8% and 5.5% for standard infrastructure trusts, with property investment trusts yielding 4.4% for UK property trusts.

In comparison, investment grade corporate bonds, which are the safest part of the corporate bond market, yield 5.4% and UK government bonds yield just under 4%.

Now that bonds yield more, with the safest bonds competing with the alternatives sector for income, are bonds the only game in town for income seekers?

It’s tempting to say that bonds really are the best place to get income, given that owning the debt of a blue-chip firm or government is a less risky proposition than buying an actively managed investment trust operating in a niche sector.

But bond investors should be aware of the following risks of the market before putting all their income eggs in one basket.

The first is the importance of interest rates to bond prices. When interest rates rise, bond prices fall, as investors know they will be able to get a better deal from newly debt. This causes the yield of existing to debt to come into line with the yield on new debt.

Bond funds are constantly buying and selling bonds, and holding some until they mature but reinvesting the returns. This means that the value of the portfolio will change as the prices of the bonds change.

In contrast, an investor holding an individual bond or gilt to maturity does not have to worry about the changes in the value of the bond as they know they will be paid back their capital when it matures and collect the coupon payments along the way, so long as there is not a default.

This means that bond fund investors could see their portfolio change markedly in value, even if they only intend to hold bond funds to pick up the income on offer. Last year, the average return for sterling corporate bond funds, including income, was a 16% loss.

Of course, investment trusts or shares held for income can also see their prices move dramatically, and they tend to be more volatile than bonds, but investors should be aware that bond funds will change in value.

Another thing to be aware of when investing in bonds is that the yield paid to investors is not always as high as they might expect.

There is a key difference between the distribution yield, which is coupon payments collected and paid out to investors (normally quarterly if held within a fund or twice a year if held directly) and the gross redemption yield, which is the implied total return if a bond or collection of bonds is held to maturity and there is no default.

Take the sterling corporate bond sector for example. It yields a little over 5%, but the coupon payments currently equate to a distribution yield of more like 3%.

The two biggest funds in the sector are Vanguard U.K. Investment Grade Bond Index Fund and iShares – Corporate Bond Index (UK).

They currently pay out a yield of 2.7% and 3.1%. This means that the actual income received by investors through bond funds is lower than the dividend yields on offer from shares and alternatives, even though the headlines yields are higher when accounting for bonds maturing and returning a lump sum to owners.

For comparison, here are some Super 60-rated and popular stock market investments paying out more than bond funds as income: Vanguard FTSE Equity Income Index (4.9%), Fidelity Multi Asset Income (4.4%), Vanguard FTSE All World High Dividend ETF (3.7%), and FTF ClearBridge Global Infrastructure (5%).

High yielding investment trusts include: Greencoat UK Wind (5%), Gresham House Energy Storage (4.5%), and International Public Partnerships (5.5%).

Why income diversification is key

I spoke with Paul Flood, a multi-asset income investor at BNY Mellon about how he views bonds versus alternatives when looking for income.

His opinion is that while bonds are far better at competing better for capital today, there is still an important place for alternatives and equities in a portfolio.

A key reason is that equities and alternatives can grow their dividends with inflation, rather than offering locked-in coupon payments like bonds.

Bonds are better at competing for capital than they were before. Renewables have sold off, but yields are now pretty attractive at around the 5%/6% mark, and they often have inflation-linked revenues, so dividends keep rising.

“Bonds don’t do that, therefore there is still a place for alternatives. But bond coupons are contractional, and dividends are not, so you get less security in your income outside of the bond market.”

James Mee, an income fund manager at Waverton Asset Management, makes the same point. He says: “Real assets grow capital over the long term and pay an income. Risk is not volatility – it is permanent loss of capital. Inflation is still leading to negative real returns on bonds.”

So what’s the best way of generating income then? As always, balance is always good. Investors should own bonds, but also equities and alternatives.

No one source of income is perfect, but a spread can build a resilient portfolio – especially now that bonds are a worthy inclusion – that can keep the cash flowing during good and bad times for the economy and stock market.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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