How income investors are innovating

  • Written by 
  • 16/09/2013
Corporate bonds 3 of 6 Introduction 1 of 6

Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Bonds have been the big winner as investors have hunted for new sources of income. Billions of pounds have poured into popular corporate bond investments such as M&G’s Strategic Corporate Bond Fund. Many investors have also turned to “retail bonds”, corporate bonds traded in quantities that are practical for individual investors.

However, equities have not been rejected entirely by income investors. Indeed, shares that pay high dividends are more in favour than ever. Income-focused investment trusts such as Edinburgh Investment Trust and Murray International Trust, for example, have become highly popular, to the point where they are trading at a large premium to their net asset value. In other words, people have been willing to pay more for these funds than the shares those funds hold are currently worth, in order to invest with the managers they believe will be most successful at producing steady, reliable income streams.

Other investment trusts such as the Aberdeen Asian Income Fund have also been trading at large premiums as investors have turned to emerging-market shares, in the hope of securing dividends that are likely to grow strongly in the years ahead. And a growing number of income investors seem willing to consider specialised assets such as infrastructure and emerging market bonds, although these remain niche investments at present.

At times like these, the income investor needs to keep in mind another investment adage: “The biggest mistake is reaching for yield.

Exercise caution in the hunt for yield

Even if it is “different this time” for interest rates, however, it will not be so for other aspects of business and investment. The income investor therefore needs to keep in mind another investment adage: “The biggest mistake is reaching for yield.” This refers to the tendency of investors to buy assets that promise a high yield in the present, without considering how secure or insecure these assets might be in the future.

If a company’s bonds trade at a yield of 10 per cent while government bonds yield two per cent, it is a sign that they carry substantial risks: the higher yield is needed to compensate investors for the risk of loss.

However, if investors attracted by the 10 per cent yield rush into the bond, they will push up its price and so lower the yield that new buyers will receive. For example, the company’s bonds may now trade on a yield of only seven per cent, instead of 10 per cent. In the short term, investors may still be pleased to receive this instead of two per cent from a government bond. But in the longer term, it may not be enough to compensate them for the risks they are running.

It is exactly at times like today when interest rates are low that this problem is greatest. Investors become too tempted by a yield that looks high compared with what is available elsewhere, without considering if it is really as high as it needs to be.

Today’s income investors are therefore in a very difficult position. They must adapt to the new investment environment by considering new sources of income. At the same time, they need to remain cautious and avoid reaching too far in the search for yield. In the rest of this article, we will look at the main options for income investing and discuss which may offer good opportunities and where you need to tread most carefully.