With economic and social uncertainty likely to be important considerations for the foreseeable future, investments that are able to generate an attractive income stream, while seeking to defend or potentially grow capital values, are in strong demand globally.
Arguably, it is always sensible to have some cash savings for a ‘rainy day’. However, with interest rates already low, and inflation eroding the value of money over time, holding cash may not always be the best approach. Instead, investors may opt to diversify and seek alternative means to generate or enhance income as a solution for their lifestyle goals.
In the same way that we are rewarded with an income for working, investors are typically rewarded with an income potential in return for providing their capital (cash) for investment. It is in effect a reward for working your money and the investment might also provide capital growth opportunities. Often, the greater the risk associated with an investment the higher the expected level of income and capital growth. You should be aware, however, that investments and the income from them may fall as well as rise and that you may not get back your original investment.
Income from investments comes in four main forms:
- Interest – this is the income from cash held on deposit at a bank or building society
- Coupon – this is the income received from bonds, which is usually paid semi-annually or annually. Ordinarily it is a fixed sum, although sometimes it is variable, otherwise known as floating, and linked to a specific measure such as the inflation rate.
- Dividend – this is the income from equities and is paid out of a company’s profits or retained earnings.
- Rent – this is the income received from tenants that is paid to the owners of a property. This can be accessed through direct investment in a property with rent being received directly or indirectly via property equities in the form of dividends.
Diversify for different outcomes
From the above we can see that different asset classes offer different types of income. With rates of return on cash close to record lows, investors may feel it timely to select alternative sources to enhance income in pursuit of their goals. This ability to choose is important because asset classes perform differently according to the economic environment. Here are two important sources as we see them:
1. Equity income
Equities could potentially provide a higher return than other investments, but they should also be considered to carry a higher risk.
At a corporate level an ever-increasing number of companies recognise the benefits of attracting investors by being able to pay attractive and growing dividends. Importantly, dividends typically generate a significant proportion of the total returns from equities over time. The combination of income that can be reinvested along with potential capital growth probably led to potential long-term outperformance of higher dividend paying companies compared to the wider equity market.
The COVID-19 pandemic has resulted in significantly reduced revenues and profits for many companies. This has led to some regions including the UK and Europe experiencing many dividend cuts from companies. Japan, Asia and some emerging markets are likely to be less severely affected by dividend cuts or cancellations, but they may experience a more delayed reaction. Dividends are therefore a strong indicator of the underlying health of the business.
This uncertain backdrop highlights the benefits of taking a diversified approach to equity income investing. Large parts of the market are looking attractively valued from a historical perspective. Therefore, we believe that an active approach to equity income enables investment in leading companies that can invest for the future and generate sufficient available cash flow to pay a sustainable dividend that ultimately has the ability to grow over time.
2. Fixed income
Bonds are debt securities (an IOU) typically issued by a government or a company (an issuer). When issued by a company they are referred to as corporate bonds. For investors they can provide a potential stream of returns. Two things are agreed from the outset: the agreed rate of interest that the issuer must pay the investor at regular intervals (the ‘coupon’) and the date at which the issuer must repay the investor the original amount (the ‘principal’).
Bonds rank above equities in the capital structure and therefore have an earlier claim on payments that a company makes. This means that while companies have the discretion to cut shareholder dividends, they have an obligation to pay the coupons on their bonds. Defaults (the failure of a borrower to meet a repayment to a bondholder) represent a threat to this form of income but defaults seem mostly impact sub-investment grade (high yield) bonds.
Investors’ goals when considering income will of, course, differ based on what they are seeking to achieve. It could be to add a more defensive feel to their portfolio, it may be to diversify, or it may be to meet a need for income generation instead of purely growth. Janus Henderson offers a range of funds designed to provide income from different sources while being mindful of the capital value of a fund. As active managers we endeavour to improve outcomes and provide solutions to suit the differing needs of investors.