In search of an income as inflation rises?

Investors needing an income from their portfolio have had a much easier time of late, in principle. Bond yields have risen as central banks have hiked interest rates, while companies have resumed pre-pandemic dividend payments. Even the humble savings account pays a little bit of interest.

However, the problem for many involved in income investing isn’t that there are no income-generating assets, but that, in most cases, income can’t keep pace with inflation. Fixed income and cash are the most obvious problem areas. While UK 10-year gilt yields, for example, rose from 0.2% in June 2020 to 3.1% in early September 2022, an investor buying today would still face an uphill battle to preserve the purchasing power of that income.

The Bank of England has forecast that UK inflation will hit 13% in the fourth quarter of 2022. Investing in a gilt today would likely mean receiving a fixed income of 3% for 10 years. This income is unlikely to keep pace with the rising cost of living even if inflation comes down in the future. Investors may still make capital gains and there are unquestionably diversification advantages to fixed income investing, but it’s difficult to make the case on income grounds alone.

There are parts of the fixed income market that offer a higher yield, and therefore more natural protection against inflation. High yield bond funds, for example, or emerging market debt funds typically have a yield of 5% to 6% (although bear in mind that past performance is not a guide to future performance).

Income doesn’t grow in line with inflation, especially at the levels predicted, but it may be high enough to allow investors’ savings to keep better pace with cost of living increases over time. The downside is, it means investors are taking greater risks at a time when the global economy looks vulnerable.

Company dividends are usually seen as doing a better job of protecting against inflation. That’s certainly been the case in the short-term. In the first two quarters of this year, dividend payments rose by 14% and 11% respectively, according to data from asset manager Janus Henderson. While some of this is undoubtedly attributable to dividends from mining and energy companies, it is also because companies have been reasonably successful at passing on higher input costs to their customers by raising prices. The auto and financial sectors saw strong growth in dividends, and 94% of companies raised their dividends or held them steady.

The longer-term picture is mixed. It’s clear that profitability in some sectors is resilient during times of high inflation – companies with strong brands, for example. However, it is not universally true. Consumer discretionary companies, for example, are likely to struggle at a time when consumers have less disposable income, so may not be in a position to raise their dividends.

An active investment manager with a focus on dividend growth should be able to target companies that continue to grow dividends in difficult markets. In this case, it can be worth targeting funds focusing on faster growing markets. There are also a number of smaller company funds with an attractive, growing income.

In the UK, the investment trust sector is a good hunting ground. The Association of Investment Companies “dividend heroes” are funds that have grown their payouts to shareholders for more than 20 years in a row. Top of the list is City of London Investment trust, which has grown its dividends for 56 years.

Alternatives have become a particularly important source of inflation-adjusted income in recent years. Infrastructure funds, for instance, can offer a compelling combination of high starting yields and inflation protection. The cashflows from infrastructure assets – schools, toll roads, hospitals – will often be inflation-linked. Adjustments will be built into the contracts at the outset, which means the cashflows from that asset – and the share price of the infrastructure fund – should increase as prices rise. The relationship won’t be perfect. Sometimes there will be caps on increases, for example. However, infrastructure funds have proved remarkably resilient this year, largely because of this inflation protection.

Investment trusts focused on renewable energy and infrastructure also offer attractive yields with some inflation protection. Examples include Greencoat UK Wind, Gore Street Energy Storage and JLEN Environmental Assets Group Limited, which invests in a diversified range of renewables projects. For these funds the income is usually derived from inflation-linked government subsidies, plus long and short-term energy contracts. Their relationship with inflation isn’t perfect either, but it is closer.

For investors willing to look at more complex options, there is a range of credit/loan-focused investment trusts that pay high yields: TwentyFour Select Monthly Income, for example, BioPharma Credit, GCP Asset Backed Income Limited or NB Monthly Income fund. However, these require detailed analysis and the underlying investment strategies are complex.

If you don’t need investment income today, it’s worth reinvesting your income back into the market. This can be more powerful when markets are at lower levels because it means you get more units to benefit from any upturn. This can work particularly well for investment trusts trading on a discount to their net asset value, where you may get the benefit of the discount narrowing as well. However, be aware this can also work in reverse.

If you’re income investing you do need to be careful in the current market environment. If your investment income doesn’t grow, its purchasing power can diminish very quickly. Don’t be fooled by a high initial yield, income growth is where the magic happens.