A window of opportunity for income-seeking investors?

Has the recent stock market peak created a buying opportunity for income-seeking investors? Iain Scouller and Maarten Freeriks, investment company analysts at Stifel think it might just have – valuations in the UK equity income sector of the closed-end fund industry are now trading at their most affordable levels for five years, they say.

In a note published this week, Stifel points out that shares in the average equity income trust are currently trading at a discount to the value of its underlying assets of around 6 per cent. By contrast, a year ago, the figure stood at below 2 per cent and only 18 months ago, the average trust was trading at a premium.

Moreover, the average discount marks some significant variations amongst the 15 or so funds in the equity income sector worth more than £150m. Several of these funds now trade on double-digit discounts – including JPMorgan Claverhouse on 11 per cent, at the limits of the discount range of 0 to 11 per cent it has traded at over the past 12 months, and Schroder Income Growth, also on 11 per cent compared to a range of 3 to 12 per cent over the past year.

Why have valuations slipped? Stifel thinks one important reason is that investors have been spooked by the peaks to which the UK stock market has climbed in recent weeks and months. “We think there has been some profit-taking and wariness on the part of investors to invest in the sector with the FTSE 100 recently reaching an all-time high,” Stifel says.

There may be other explanations too for the UK equity income sector falling from favour. One possibility is that investors aren’t keen on the underweight positions many funds in the sector have in mining and oil stocks, which have been strong performers during 2016. Another is that investors anticipating interest rate rises over the next year or so are worried about how this might affect demand for funds where yield has been the primary driver of demand.

Still, even putting aside the debate about the prospects for capital growth from equity income funds, the yields they offer right now look very enticing compared to what is available elsewhere. A number offer a dividend yield of 4 per cent or more. “Many of these trusts also have significant revenue reserves, which can be used to maintain and smooth dividends from the trusts at times of dividend cuts in the equity market,” Stifel adds.

Moreover, the Bank of England said this week that the chances of interest rate hikes were falling given the prevailing economic climate, suggesting that rates are unlikely to rise any time soon. That suggests the equity income sector is going to remain lucrative hunting ground for investors in search of yield – and also that its fall from favour may only be temporary. In any case, even if rates do begin to rise, there will need to be several increases before cash deposits in bank or building society accounts start to close the gap on what is currently available in the equity income sector.

Investors will, of course, have to be prepared to accept downside risk – that there is a chance of your capital falling in value as well as rising. But if you’re prepared to do that – and to take a long-term view of, say, five years or more – equity income investment companies may be a good option for income seekers, and this period of wider discounts may represent a window of opportunity.