Invesco: Are income funds a good investment?

Benjamin Jones, Director of Macro Research

Key takeaways

• Over the last ten years, income funds have not looked so attractive. But things are changing.

• If you look back over time, a pattern emerges. In periods of macro uncertainty and inflation, cash flows today are preferable to uncertain capital gains tomorrow.

• Active management allows investors to balance the risks with the opportunities. We share insights from our equity, fixed income and multi asset teams.

Over the last decade, investment returns have largely been driven by capital gains. Equity multiples have expanded, most notably in the tech space, while falling bond yields have meant higher bond prices. Since the Global Financial Crisis (GFC), income has been a much smaller contributor to returns, as central banks backstopped markets and held down the discount rate.

But it was not always this way.

Let’s look back through history. If we direct our attention towards periods of high inflation, higher rates, and greater macro uncertainty, we can see that income looks attractive. We’ll explain this in further detail in a moment with reference to Figure 1, but the basic principle is simple. In a challenging environment, cash flows today are preferable to uncertain capital gains tomorrow.

A closer look

The below chart from Goldman Sachs compares the Sharpe Ratios of the S&P 500 Index, the US 10-year Treasury note and US high dividend yield stocks. Sharpe Ratio is a measure of returns relative to risk. The higher the Sharpe Ratio, the more attractive the risk adjusted return.

Looking at the chart, we can see that high yield stocks have a much better Sharpe Ratio in the 1970s and 80s than the other two lower yielding indices. Inflation was high during this period. In other words, allocating to stocks with a high dividend yield improved investors’ risk-adjusted returns in these environments

Figure 1. In periods of macro uncertainty, high yield stocks have had better risk-adjusted returns

*Allocation to maximise Sharpe Ratio. 10-year rolling monthly returns. Source: Goldman Sachs Investment Research, Kenneth French, Datastream. Data provided as at 31 December 2021. US High DY = funds defined by EPFR as having an income mandate and providing an above average yield. 

The search for income has proved challenging

You might think high yield stocks should have performed well over the last decade, as investors were starved for yield in other areas. For example, in fixed income, both nominal and real yields were forced below zero. Moreover, by late 2019 nearly a third of all sovereign bonds globally carried a negative yield. The situation has improved somewhat in the last six months, but yields are still not especially high by long-term historical standards.

Figure 2. There is less negative yielding debt today

Source: Bloomberg

However, while equities did pay a higher yield than bonds, the situation was not all that different. The dividend yield on the MSCI World Index dropped below 2% for the first time since the late 1990s and a growing share of firms paid no dividends at all.

The chart below shows the proportion of firms (by market value) that have never paid a dividend (purple line). It also shows those that paid no dividend over the previous year (green line). Both series have risen substantially in recent years, as firms with attractive long-term (and sometimes highly speculative) growth stories have captured investors’ imaginations and outperformed.

It is not that these companies were reinvesting earnings, but rather they had little to no earnings in the first place. This didn’t matter when the interest rates and therefore the discount rate applied to stocks was at or close to zero. But the discount rate is rising now, and the value of future uncertain earnings has fallen precipitously.

Figure 3. The number of non-dividend payers surged during the pandemic

Source: Société General as at 30 June 2022. Universe represented by MSCI World Index.

There is a growing consensus that the great moderation of the last thirty years is over. In other words, investors will need to become more accepting of greater macro instability and central banks that are less willing to backstop financial markets. In the past, income has played a much greater role in returns under these conditions.

That said, we note that screening on yield alone is too simplistic an approach. Stocks can display a high yield because their prices have collapsed for good reasons, and future dividends may need to be questioned. Yields can also be highly volatile during times of stress and earnings downturns.

As such, we prefer to seek out dividend growers and companies that can keep up with future payments. These yields don’t tend to be the highest, but they do tend to be more reliably delivered. This is where active management can help to construct a low volatility income strategy.

A deeper dive: in conversation with our investment teams

I caught up with Lewis Aubrey-Johnson (Head of Fixed Income Products), Neville Pike (UK Equities Product Director) and Georgina Taylor (Multi Asset Fund Manager). They shared their insights on income and outlined the opportunities they’re seeing today.

It is well understood that inflation is harmful to bond investors, as it erodes the purchasing power of both the coupon and the principal. As a result, bond investors are sensitive to the risk of inflation and require an additional component of return in the form of higher coupons to compensate for it – the inflation premium. Investors typically want to know that a bond will earn a positive real return, which is simply a positive return, even after inflation has been considered.

Of course, while the nominal return for a single bond that is held to maturity is fixed, a bond’s return in the intervening period can be either supplemented or eroded by changes in its price. If the threat of inflation is falling, investors will demand less of an inflation premium. As a result, bond yields decline, and prices rise. If inflation is rising, then the premium must also adjust, forcing yields higher and prices down.

Figure 4. UST 10-year yield and US core CPI (%)

Source: Macrobond as at 12 September 2022.

Inflation: a threat and an opportunity

It’s not the absolute level of inflation that counts for bond investors, so long as they can earn a positive real return over the medium term. Rather, it’s the direction of travel. For while the rise of inflation presents investors with the greatest threat, so too can its decline present the greatest opportunity. The role of active bond fund management is therefore to adjust risk according to future trends in inflation and monetary policy.

Outlook: where are bond markets headed?

We think bond markets have already made a significant adjustment and are pricing in a much more realistic scenario about the need for interest rate hikes. This is not to say that yields have stopped rising altogether. Inflationary pressures are widespread and increasingly ingrained. But a significant degree of tightening has already been priced in (more than any other time since the late 1970s) and there are early signs that the general financial tightening we have seen is beginning to bite. 

The 50-year chart below shows the actual level of income paid out in dividends by companies in the FTSE All-Share index. It also shows the value of the FTSE All-Share index itself. Both measures are compared to inflation in a notional basket of goods. This is indexed to 31 December 1971.

The chart assumes that dividends paid out by companies are drawn as income. It ignores any returns from the reinvestment of dividends which, in practice, is a powerful driver of total return.

Figure 5. Income paid by FTSE All-Share companies over time

Source: Bloomberg as at 31 May 2022.

Let’s draw out an example to bring the analysis to life. Imagine someone was invested in the FTSE All-Share in 1971, with sufficient funds to receive a dividend of £100. Just over 50 years later, in April 2022, they would have seen their income (and capital) grow at a compound rate of 6.3% per year.

This is significantly above the 5.1% rate of inflation over the period. Put another way, the real income (income adjusted for inflation) was 75% higher at the end of April 2022 than it was in December 1971.

Managing risks and reinvesting returns

An active income manager can potentially mitigate the effects of equity income volatility. This might be achieved through thoughtful diversification and balance within a portfolio. Careful stock selection is also important, taking due consideration of dividend cover instead of simply targeting high headline yields.

An individual investor might also look to draw a base level of income and reinvest any ‘excess’ growth during the many periods when income grows above inflation. This could then be drawn down during the less frequent periods of below-inflation dividend growth to maintain the income stream in real terms.

Using equity market pairs

As well as simply buying equities, we can generate dividend income by choosing equity market pairs. This allows us to generate an income but take less capital risk or have some long positions and some short positions side by side.

When we sell a market, we hold the cash equivalent to cover the position. If the interest rate on that cash is higher than the dividend yield that we would be paying to the other party who is buying the market, then we make a positive income from holding the position.

Opportunities in emerging markets

Within the rates market, emerging market government bonds currently offer an attractive yield. However, we need to be mindful of the currency exposure given the capital risk which is inherent in emerging market investments. Macro uncertainty and the larger carry opportunities available at present mean the FX hedging decision has become more important of late.

Carry trades: a fruitful source of income?

FX carry opportunities have been sparce in recent years, but that is now changing. A good example of an attractive carry trade we have observed is being long the US dollar versus the Taiwanese dollar. This position has been generating an attractive income for our portfolios.

What role do derivatives play?

We can also use derivative instruments to generate income. Volatility has increased during the market turmoil. However, if we believe that markets will stabilise, we can sell options to generate an income. For example, if our central view is that equity markets will fall a small amount from here but not too far, we can sell a ‘10% out of the money’ put option.

Assuming the market doesn’t fall by more than 10%, our return is the income we receive from the sale of the put option to another market participant.