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Growing gains

Investors are sticking with UK equity income funds which offer medium to long-term growth potential.

The equity income sector continues to dominate the industry sales figures. The reasons are obvious. We are not getting any younger and, while looking for investments with the potential for capital appreciation alone might be suitable for investors with a longer time horizon and no expense commitments in the interim, the majority of us have a need for at least some level of income from investments.

Time was that investors in the UK at least would look to a mix of the bond sector and UK equity income funds to fill that need. However, as we all know, conditions in the market have changed and gilt yields have moved down quite sharply. Today, 30-year gilt yields are just 5.3 per cent, a scant 0.05 per cent more than the base rate in the UK. Clearly, then, while looking to bond funds for income still has some potential in the UK and has been beneficial for those investors who have been able to participate in the gradual reduction in yield levels in recent years, the absolute level of income available from government bond investments in the UK may not meet every investor’s needs.

Corporate bonds have also long been a favourite with UK investors looking for income but a similar story applies here. After the strong performance of government bonds in recent years and the inc-reased appetite for risk on the part of investors generally, the additional yield available on corporate bonds above government bonds is not always very high and for many investors, the key question should be whether this modest pick-up in yield is justified by the additional level of risk being taken on.

Unlike government bonds, which are backed by the Treasury, corporate bonds rely on the credit rating of the issuing company. This can become an issue when investing in bonds issued by companies with a lower credit rating – so-called sub-investment-grade (or junk) bonds. Of course, that is not to say that corporate bond funds should be overlooked by investors looking for income but the key is knowing exactly what risks are being taken by the investment manager in the portfolio and how this relates to the investment strategy.

For these reasons, UK equity income funds have become the preferred option of investors in the UK. Although yields are not particularly high – the FTSE All-Share index currently yields 2.86 per cent, for example – this is primarily down to the strong rise in the level of the index over the last few years. Dividend growth is healthy and our expectation is that this area offers good potential both for income and capital growth over the medium to long term.

A number of investment managers are looking further afield to find possible solutions for investors looking for income from traditional bond and equity funds. Dividend growth in Europe, for example, is running substantially ahead of the rate of growth in the UK.

Another new approach is fast gaining favour. It is a hybrid approach to income investing in the emerging markets which combines the potential for capital growth offered by emerging equity markets with the attractive level of yield available from local-currency-denominated emerging market debt.

If we are talking risk-adjusted return, perhaps we should also look at the Asian equity markets for income. The level of volatility in the Hong Kong equity market might be higher than that in the UK but if the capital returns of recent years are any guide to the future, investors might be enjoying both income and capital growth – the holy grail of the investment industry.

Ian Pascal is marketing director at Baring Asset Management.

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