A new home for income investors?

The change in financial markets over the past 18 months has been remarkable. For much of the last 15 years, income-seeking investors have bemoaned historically low interest rates; these have driven down returns on cash accounts to paltry levels and depressed yields on fixed-income assets such as bonds. Today, by contrast, aggressive monetary policy tightening by central banks, including the Bank of England, has changed everything – bonds are no longer an income desert.

For income seekers, that creates an interesting question. In recent years, they have felt compelled to turn to more risky equity investments to find yield; the UK Equity Income sector of the investment company industry has been a favoured option for many. Now, however, the bond market, traditionally considered to be less volatile, looks much more competitive. Should people switch?

After all, the average UK Equity Income investment company currently offers a yield of 4.4%, albeit with plenty of variation from one fund to another. But 10-year US Treasury bonds, considered a super-safe investment, offer around 4.6%, while some UK gilts yield above 5%. On corporate bonds, issued by companies, yields have gone even higher.

On the face of it, this is a no-brainer. If you have £100 to invest today, you’ll get significantly more income over the next year if you put it into bonds than most equities will pay. So, if income is the primary goal of your investment strategy, that looks a smart option.

However, the debate is not quite as straightforward as it seems, especially if you’re thinking about any time period other than the very short term.

One important point is that bonds are fixed-income assets. That is, they pay a fixed coupon each year. If you buy a bond paying 10p of income a year, that’s what it will still be paying you in ten years’ time (assuming no default). And by then, inflation will mean your 10p is worth much less than it is today.

Equities, by contrast, pay variable levels of income. Companies change their dividend pay-outs from one year to the next, depending on how well they are performing. This creates the potential for rising dividends, protecting the value of your income from the destructive power of inflation.

Many investment companies recognise this allure and build portfolios of shares they think will give them the best possible chance of raising dividends. That includes 20 funds – many of them to be found in the UK Equity Income sector – that the AIC describes as its “dividend heroes”. These are funds that have raised their dividend payment in each year for at least the past 20 years. There is also a “next generation” of heroes – almost 30 funds that have a track record of annual dividend increases that goes back at least one decade, but less than two.

The other consideration here is capital performance. In the past, equities have indeed been more volatile assets than bonds – that is, they have exposed investors to greater ups and downs on price. But over longer-term periods, they have also tended to deliver larger returns than bonds.

What we have here is a classic “jam today” dilemma. On income payable immediately, bonds currently have the edge over equities – and that has not been the case for some time. On a medium- and longer-term view, however, many investors will feel the potential for rising income and capital growth, though not guaranteed, means equities still have the edge.

One final point. Don’t get confused by jargon. A yield simply tells you what it currently costs to buy the income on offer from an investment. A bond priced at 100p paying 5p of annual income, say, yields 5%. Over time, however, yields fluctuate because the price of the bond fluctuates. Once you own the bond, you’re locked into the income you were promised at the outset, which doesn’t change, so the fact that the yield has moved is irrelevant in that context.

Yields can also be confusing with equities since there is potential for both the share price and the dividend to change. Both will affect the yield. Income seekers therefore need to stay focused on the prize – the cash income they’re in line to receive.