QD view – Divining higher income in an inflationary environment

230707 Sterling cash inflation QD view

As I write this, the outlook for the UK equity market looks particularly depressed. As I discussed in my QD view “Bargain Britain” two weeks ago (click here to read), inflation in the UK has remained stubbornly high, which was somewhat of a surprise to many commentators who had expected to see signs of this rolling over, what with energy costs on the wane.

With higher inflation comes higher interest rates, which it seems will probably persist for longer as the UK’s central bank tries to draw heat from the economy. The Bank of England’s base rate is now 5% – the highest rate for 15 years – but commentators are now talking about a peak as high as 6.5%, which implies both higher mortgage rates (the mortgage market is in turmoil and this shows little sign of abating with the Halifax, Britain’s largest mortgage lender, pushing its interest rates up on Wednesday and other lenders such as Lloyds, TSB and Santander following suit) and greater government borrowing costs (the UK government has just sold £4bn of gilts, maturing in October 2025, at an interest rate of 5.668% – the highest since for a bond of this maturity since the Debt Management Office was established in 1998 – according to the FT).

Add in the fact that the UK government’s finances, which already looked weak, appear to be on a deteriorating trend (June saw UK government debt rise above 100% for the first time since March 1961 – the highest in over 62 years – and the government plans to sell some £241bn of gilts this year, up from £139bn issued during 2022) and there is much for people and markets to worry about.

Persistent inflation – in part a pandemic hangover

Part of the reason inflation has remained high appears to relate to the effects of the pandemic, which saw some workers leave the workforce permanently. This has reduced the pool of available talent and helped sustain higher employment levels, putting upward pressure on wages. ONS data suggests that average weekly pay (seasonally adjusted) has increased by 7.4% over the year to April 2023. There are disparities between sectors (finance and business services sector saw the largest regular growth rate at 8.3%, followed by the construction sector at 6.2%) but some commentators think that wage inflation may actually be even higher and has not yet peaked. If they are correct, inflation may persist for even longer and an environment of higher interest rates may yet be with us for some time. This is something that investors, particularly those in search of income, will have to adjust to.

Real-terms erosion of savings

In some ways, higher inflation is both a blessing and a curse for the income focused investor. Yields on bonds and savings accounts have been meagre in the post-GFC period and these have perked up significantly as inflation has risen. Some banks are now offering 6% on deposits but, with inflation running at 8.7% in the year to 31 May 2023, savings parked with banks are still being eating into in real terms.

Debt versus equity

If you listened to James Carthew talk to Gervais Williams last week (click here to view), you will see that investors are still selling down equities to buy bonds, but maybe that makes sense given the returns that they have been experiencing.

Bond funds, which you might expect to flourish in an environment of rising interest rates, have held up better than UK equity funds in the short term (the median return for the Debt – loans and bonds sector is 0.86% over six months, while the UK equity income sector is -1.64%), yet over 12 months, the median return for Debt – loans and bonds over 12 months is 3.7%, which is behind that of UK equity income of 6.2%. However, these are not necessarily a long-term solution – over 10 years, UK equity income has given you an extra 2.1% per annum compound and, in an inflationary environment, equity tends to outperform debt.

Screening for yield and positive total returns

Against this backdrop, I thought it would be worth picking out some of the higher yielding bond funds and UK equity income funds that have provided superior long-term total returns. For the yield requirement, I am looking at funds that provide a yield in excess of 6% as this is what can currently be achieved on bank deposits. For the total return requirement, I am using a total return in excess of 4.5% per annum, taken over 10 years to smooth out the effects of the pandemic and, to a lesser extent, the aftermath of the referendum, which still distorts the five-year numbers.

Not many make the cut from UK equity income

Not surprisingly, there are relatively few that meet these stringent criteria – having a higher bar for income tends to limit your capital growth prospects. From the UK Equity Income sector, only one trust makes the list – Chelverton UK Dividend Trust. However, with a market cap of just £35m and a spread of 5.1%, it is not going to be suitable for many, although its yield of 7.8% allows it to trade at a premium to NAV (5.9% at the time of writing).

Debt – Loans and bonds – the chosen few

From the debt – loans and bonds sector, three funds make the cut: CQS New City High Yield (NCYF), CVC Income and Growth’s sterling shares (CVCG) and Invesco Bond Income Plus (BIPS).

Of the three, NCYF has the highest yield at 9.9%. This is the highest yield on offer in the debt – loans and bonds sector, with the next highest being 9.0% from the soon to be defunct NB Global Monthly Income Fund (NBMI). However, NBMI’s yield is high for a reason – it has provided a total return of -0.2% per annum over the last 10 years, so has lost you money in absolute terms (let alone real terms) and so some might reasonably label it a value trap.

CQS New City High Yield – cheap versus history, despite yield and long-term performance

CQS New City High Yield has, in contrast, provided an NAV total return of 4.75% per annum; the second highest in the sector. The combination of high yield and outperformance is why this fund tends to trade at a premium to NAV (these were factors I cited as being behind its premium when I wrote about it in February last year – click here to read). Today, NCYF looks cheap relative to history – its currently trading at a discount of 1.0% versus a five-year average premium of around 5% but based on past experience I would not expect this to persist.

NCYF invests in a portfolio of predominantly higher-yielding fixed income securities with the aim of providing a high level of quarterly income, with some prospect for capital growth. Its veteran manager, Ian “Franco” Francis, aims to build a “sleep at night” portfolio that it is well suited for investors looking for a high level of income that don’t wish to take too much risk with their capital. This seems to have played out in its recent NAV performance (NCYF’s NAV total return is -0.7% over six months), although this has not been reflected in NCYF’s share price (NCYF’s share price total return is -12.4% over the same), hence the move to a discount.

When we wrote on NCYF in May last year, we commented how Ian felt that interest rate rises maybe too little, too late, and this appears to have come to pass. However, he positioned NCYF’s portfolio accordingly, edging up the exposure to equities, which has been to NCYF’s advantage.

CVC Income and Growth – Also cheap despite yield and outlook

CVC Income and Growth has experienced somewhat of a purple patch. In its annual report for the year ended 31 December 2022, its chairman said that he believes the current market conditions are inherently attractive for the company. Specifically, the combination of increased credit spreads, taken together with increasing risk-free rates on offer by central banks, have driven the yield on the underlying portfolio to levels not seen for many years.

At the end of February 2023, the yield to maturity on underlying portfolio was 17.3% (euro-hedged) / 19.0% (sterling-hedged), with running cash yields of 11.5% (euro-hedged) / 13.1% (sterling-hedged). Floating rate instruments at that date comprised 83.2% of the portfolio and with then prevailing economic conditions and inflation data suggesting that, both in Europe and the United States, a “higher for longer” expectation for risk free rates, this indicated continual favourable conditions for the fund as its manager deploys capital to fresh positions at higher all-in rates. At the time of writing, CVCG offers a yield of 7.7% (with quarterly dividend payments) and is available at a discount of 6.8% which, like NCYF, is cheap relative to its history.

Invesco Bond Income Plus – compelling long-term performance but expensive versus history

Invesco Bond Income Plus invests in high-yielding fixed-interest securities with the aim of providing both high income and capital growth. It was previously known as City Merchants High Yield but adopted its current name when merged with Invesco Leveraged High Yield in May 2021. However, it retained its fund manager, Rhys Davis, who is responsible for its long-term track record. The merger brought additional scale and elevated BIPS to the position of largest fund in the Debt – loans and bonds sector. It currently offers a yield of 7.1% (with quarterly payments) and has returned 4.7% per annum over the last 10 years (modestly behind NCYF, which is arguably its closest competitor).

Interestingly, BIPS NAV total performance of 3.8% during the last twelve months has been more than compensated for with a share price total return of 11.9% as the trust has moved from trading at around a 6-7% discount to around a 2% premium today. This makes it, with the exception of exiting NBMI, the most expensive trust in the Debt – loans and bonds sector at the time of writing. Its current premium 1.7% compares against a median discount of 5.0% and it is the only fund in that sector, aside from NBMI, that is trading at a premium.

Finally, I’d like to talk about Henderson High Income (HHI). As the sole remaining fund in the UK equity and bond income sector, I think it often gets overlooked, undeservedly. With a current yield of 6.5% and a 10-year NAV total return of 5.8% per annum, it clears our yield and return hurdles with ease. It’s also had a pretty decent 12 months with NAV and share price total returns of 3.9% and 4.3, reflecting the fact that it has tended to trade in a range of around 2% above and below par during the last couple of years.

Henderson High Income – UK equities enhanced by an allocation to bonds

Henderson High Income differs from the above higher yielding funds in that the bulk of its portfolio invested in listed UK equities, both well-known and smaller companies, rather than in bonds. However, it also has a portion of its gearing (typically equivalent to around 22-24% of net assets) allocated to fixed income investments. This strategy offers a number of benefits to shareholders as it enhances HHI’s income returns, dampens the overall volatility of the portfolio, and should help to achieve greater capital growth over time.

Although not a perfect fit, we would like to see HHI moved into the UK equity income sector, given the bulk of its investments are in this area. In the meantime, we think that this peer group offers the best basis against which to assess HHI’s characteristics and performance. Not surprisingly, with its higher income focus, HHI’s yield is way above the median for the peer group of 4.6%. However, perhaps more surprising is that while it is behind over the last 12 months (the sector median NAV total return is 6.2%) this higher income doesn’t appear to have come at the expense of total return over the longer-term – over 10 years, HHI’s NAV total return is 5.8% per annum is around 0.4% ahead of the sector median. Its overweight allocation to equities was a key driver of its outperformance during 2022, and we think that it can continue to benefit from the inherent inflation protection offered equities.

The time is now

With the prospect of inflation persisting and further interest rate down the line, it might be time to think about additional inflation protection for your assets. While banks have increased their interest rates, the evidence is that they are not passing on all of the benefits – the best headline rates are still not enough to stop savers from getting poorer in real terms. Banks are indeed being berated for profiteering and expanding their net interest margins but, while this may have an impact in the longer-term, it doesn’t appear to be acting as a much of a brake in the short term. Closed-end funds, which don’t have to sit on under-earning cash to fund redemptions, are one place that investors can look to for solace. As the above discussion shows, it may not be possible to offset the full inflationary costs in the short term, but there are certainly plenty of opportunities that can offer a decent yield and the prospect of capital growth over the longer-term, which should go a long way to limiting its impact.

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