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Income taxing

Income has always been a popular part of investing and the surprise 1.5 per cent drop in UK bank rate has certainly made achieving it a lot harder, that is without accepting some risk to capital.

With clients, advisers and fund professionals all wondering which way the equity market will go day by day, investing in a fund is fairly low on the priority list for some investors. But income streams have been damaged by the fall in interest rates and other typical low-risk strategies are also looking unattractive at present. The Government-backed National Savings & Investment products are linked to RPI, which is falling now that inflation is less of a concern.

Jupiter CEO Edward Bonham Carter noted that the Bank of England’s big rate cut this month is not necess-arily good news for savers as it will reduce their interest payments by up to £15bn. “They will, as a result, be increasingly keen to find sources of safe and reliable income,” he added.

But are equity, property or bond investments likely to help shore up that need for income?

As every investor continues to hear on a daily basis, the recessionary environment is making life tough for businesses, meaning cuts in company dividend payments may become the norm in the months ahead. And, of course, one of the biggest dividend-payers in the UK market – banks – are having to suspend dividend payments.

Still, equity income fund managers are not without belief in the sustainability of their funds’ ability to produce an income stream. Tineke Frikkee, manager of Newton higher income, feels reasonably optimistic about the ability to deliver some dividend growth in 2009.

He says: “The loss of UK banking dividends in 2009 will be made up by the recent strengthening in the US dollar versus sterling. In 2009, 35 per cent of UK dividends will come from UK companies that report their earnings and declare their dividends in US dollars.

“The currency move means we will see more than 30 per cent dividend growth from some UK companies such as Shell, BP and AstraZeneca. In addition, other companies with relatively defensive earnings and strong balance sheets are likely to deliver above-inflation dividend growth in 2009 – such as Centrica, GlaxoSmithKline, British American Tobacco, Pearson and Cable & Wireless.”

Jupiter income’s Tony Nutt expects some firms in need of capital will divert cash away from dividends to repay loans to stay afloat. “We can expect more dividend cuts in a number of sectors, not just banks but also housebuilders and retailers,” he says.

Nutt predicts that dividend growth for the entire market will be flat next year, or even negative.

But there are companies that will continue to reward shareholders. Many such businesses exist, he said, noting they can be found in the beverages sector, among pharmaceuticals, in utilities and tobacco, in a range of specialist engineering companies, among the oil majors and even in certain financials. Stockpicking equity income funds should do well in such an environment, he explains.

On the bond side, the yields on offer at the moment are certainly attractive. In fact, the opportunities in this sector, with prices having been driven down to such distressed levels, is leaving some fund managers excited about the asset class for the first time in years. Invesco Perpetual’s Paul Read said he is bullish at the moment, as is M&G’s Jim Leaviss.

“There is hardly a bond price that has not been marked down,” said Read. “With the marking down of prices comes the widening of spreads. The market is now discounting in terms of default and whether you look at corporate bonds or high yield, they are unprecedented and extremely unlikely levels of default.”

Although Read is relatively gloomy on the overall market outlook for the months ahead, that does not stop him being positive on bonds as he feels that most of the bad news is already priced in.

Leaviss, head of retail fixed income at M&G, is also bullish and says there are opportunities in almost every side of fixed interest.

“We are adding credit risk to our portfolios and are overweight credit risk across our investment-grade bond funds for the first time since 2005. We continue to be very bearish on the global economic outlook but BBB corporate bond spreads (using US data) are the widest since July 1932.”

He comments that there are also opportunities in high-yield issues, albeit selective ones as he does expect there will be a large number of defaults in the highest-risk bonds over the second half of 2009.

Property is another traditional income provider but it too has seen some dramatic falls of late and it does not look like it will get much easier for this asset class in the short term, at least as far as the UK market is concerned.

Although rental yields are looking attractive among commercial properties, their capital value has already been substantially marked down and, with retail companies under pressure, it could have a knock-on effect for occupancy rates.

Capital values of UK commercial property have fallen by around 24 per cent from July 2007 to October 2008, according to Standard Life Investments.

One of the UK’s biggest property investors, Land Securities, reported its earnings last week and said it has seen a £1.7bn loss – mostly due to writedowns in property value – but income streams have remained high, it added.

Standard Life Investments is light on the UK commercial property market and intends to stay that way in the short term, even though it notes some improvement in yields. But it does see opportunities elsewhere in property and prefers the Asian market. So too does New Star, which has its international property fund heavily weighted to that region.

Although the picture for finding income may look gloomy from a low-risk product point of view due to falls in interest rates and the likelihood they may fall further in the months ahead, there are still income opportunities available.

In order to achieve any income in this environment however, clients will have to accept the capital risks that accompany them. There may be risks in the main asset classes of equities, bonds and property but they may also be the only recourse open for those seeking an income stream.

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