Redmayne Bentley Publications Podcast April 2024
1875 Spring 2024 – Income Insights
We are pleased to present the audio version of our Spring 2024 edition of
1875.
TRANSCRIPT
Welcome to the audible version of Redmayne Bentley’s 1875 publication. In this edition of 1875, out attention turns to income, exploring Pensions Freedom reforms announced a decade ago, alongside potential in healthcare real estate, multi-sector bond strategies and emerging marketing.
Investments as well as income arising from them can rise as well as fall in value. Past performance and forecasts are note reliable indicators of future results and performance. There is an extra risk of losing money when shares are bought in some smaller companies. Redmayne Bentley has taken steps to ensure the accuracy of the information provided. Please note that this communication is for information only and does not constitute a recommendation to but or sell the shares and the investments mentioned.
Income Insights for the New Tax Year
Alastair Power, Investment Research Manager
The new tax year is upon us and the focus for many is likely to be on completing ISA subscriptions or moving funds from taxable accounts into their tax advantaged equivalents. Some key changes come into effect this year, with further reductions in allowances for capital gains, dividend, and interest making tax-efficient portfolio management decisions trickier. For the second iteration of
1875 in 2024 our focus turns to income with a look back at the Pension Freedoms announced nearly a decade ago and some potential areas of interest for those investing for income and total return.
In our Stock Focus article, we explore Primary Health Properties, a UK-listed Real Estate Investment Trust (REIT). The underlying portfolio comprises £2.8bn of high-grade healthcare-related properties, offering inflation-linked cashflows with the Government as the primary counterparty. Through the recent periods of near-zero interest rates, investors were willing to pay a hefty valuation for the company’s shares and secure dividend income stream. At its peak in 2020, the shares traded almost 60% higher than the reported net asset value and yielded 3.5%. Recently, the story has flipped, with shares at a 13% discount to net assets and yielding 7.4%. Development activity for the portfolio has stalled with associated costs rendering new projects economically unviable. Attentions have shifted, however, to the Irish market where deal sizes are larger, yields are higher and a recent acquisition has proven beneficial. However, hurdles do remain, and these will be explored further within the article.
Away from property, we turn our focus to the largest global asset class: fixed income. Higher interest rates have caused a corresponding move in yields and a renewal of investor enthusiasm for the asset class estimated to have been worth US$133tn in 2022. UK retail investors tend to remain focused on allocating within the Sterling markets, limiting themselves to just 3% of the global market. The asset class encompasses significantly more than government and corporate bonds. Professional investors in the space have access to a myriad of sub-asset classes, including securitised bonds such as mortgages. Accessing these areas directly can be tricky, but many large players such as US asset manager PIMCO offer individual investors access to its multi-sector bond strategies, within which you’ll find holdings across mortgages, corporate bonds, treasuries and emerging markets, among others.
Finally, we explore an area not normally considered when discussing income investing: emerging markets. A catch-all term covering developing countries who haven’t yet fully met the characteristics of a developed nation, emerging markets include economies such as Brazil, India, and China who respectively rank ninth, fifth and second in the list of largest global economies. There are some high yielding companies in the sector, such as Bank Rakyat Indonesia, the bank which has managed to corner the country’s micro-lending sector, on a dividend yield of 5.6%. Currencies and tax treatment remain two key issues of dividend investing in emerging markets, but with further economic development and maturing of financial markets, the region could become a more regular feature in income-focused accounts going forward.
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Primary Health Properties
Oscar Sheehan, Investment Executive
For many investors, generating income is their primary focus. Following recent interest rate rises, many of the investment trusts and funds that invest in income-generating assets, such as corporate bonds or property, were forced to rerate as a result of the increased return people could make by buying government bonds. While this was bad news for anyone holding those investments at the time, as their value tended to drop significantly, it does now mean that the yield on offer from many investments is the highest it’s been for well over a decade. Real Estate Investment Trusts (REITs) are one group of investments where this has occurred, and in this month’s Stock Focus we thought it would be interesting to take a closer look at Primary Health Properties (PHP), a REIT that specialises in providing high-quality facilities to the healthcare sector, such as GP practices. When assessing whether or not investments such as this are worth the risk associated with them, it is important to take time to understand both the wider sector and any idiosyncrasies associated with the specific investment.
Income-generating assets such as PHP are often spoken about in conjunction with UK Government bonds (also referred to as gilts). The return you can get on these bonds is referred to as ‘the risk-free rate’ as it is considered unlikely that the UK Government will default on its debt. It is worth noting that it is not technically risk-free, as governments can and do default on their debt. However, the logic goes that the likelihood of the UK Government defaulting on its bonds is lessened because of the other options it has to pay these off such as issuing more debt, raising taxes, or cutting public spending. As a result of this being considered almost risk-free, investments in riskier income-generating assets generally must return more money to investors in order to encourage them to take on this additional risk. At the time of writing, the annualised return an investor could expect on a 10-year gilt, if held to maturity, is 4.24%. This is substantially higher than it was back in 2020 and this is largely due to the increase in interest rates we have seen since then. As people need compensating for taking additional risk, PHP has seen its yield increase from 3.5% in 2020, to just under 7%. While this has been bad news for people who bought PHP in 2020, as for the yield to increase the share price has had to drop considerably, it does now make the sector potentially appealing for those who need their investments to generate a high amount of additional income.
It is important to understand this concept when considering adding infrastructure or real estate to investment portfolios as they are interest rate sensitive assets. The flip side to this is that if rates are cut, the share price for investments such as PHP would very likely rise. Therefore, in theory, investing when interest rates are high could allow investors to lock in a high yield and then benefit if interest rates are cut, as many predict they will be, later in the year. Of course, this depends on interest rates falling, if they were to rise again investors would be exposed to even further capital losses.
Another key benefit of investing in REITs over government or corporate bonds is that they offer the opportunity for dividend growth, while bonds typically pay out fixed coupons, although there are exceptions, and bonds can be more complex than people give them credit for. PHP has an excellent track record of generating dividend growth for its investors and has increased its dividend payments every year for almost three decades. Of course, as a listed company, there are no guarantees of returns for investors in PHP and all invested capital is at risk. However, one thing that may well give investors a degree of comfort is the quality of tenant that PHP does business with. 89% of its leases are underpinned by the UK Government via the NHS, giving it a very predictable and stable source of revenue. You could find other REITs with higher yields, but this level of security is difficult to replicate.
This level of government-backed income is what separates PHP from its competitors. Assura is a healthcare-focused REIT that invests in the same type of property. The primary differences between the two have been Assura’s commitment to constructing new holdings in an environment in which it has not been cost effective to do so, and its increasing focus on the private medical sector. Long-term, this may well pay off, but so far this has not been worth the additional expense and risk taken. PHP has seen its share price hold up in times of market volatility, and part of the reason for this has been that it has concentrated almost all its new activity in Ireland, where construction of new properties remains profitable.
Currently, PHP has 9% exposure to the Irish market with a long-term target allocation goal of 15%. PHP’s more disciplined approach to expansion has served it well during the high interest rate environment and its share currently trades at a substantial premium to Assura’s. While Assura’s increased volatility does now mean that its yield is slightly higher at 7.85%, it remains unclear if this additional income is worth the increased risk.
PHP may well be a best-in-class investment, but whether or not that class is appropriate for you is an entirely different question. The yield on offer is attractive, but this is mostly because its share price has dropped 29% over the last five years. In high-inflation, high-interest rate environments PHP will likely struggle to perform, even this year its share value is down 9% and rates have not risen further. It is important that we do not see REITs simply as bonds with a better return profile. They are property investments that trade alongside equities on the London Stock Exchange and as such can demonstrate a large amount of volatility when compared to shorter dated government bonds and we should only take on as much risk as is absolutely necessary to meet our objectives.
The Changing Face of Retirement Income
Greg Lodge, Performance & Risk Analyst
How to take an income in retirement is a question nearly everyone has to consider. While the pensions landscape has changed dramatically over the years, retirement income can be a more complex business than ever before. It’s been ten years since the 2014 Spring Budget when then Chancellor George Osborne announced a raft of significant changes in how retirement income could be taken. Prior to this, retirees had been compelled to buy an annuity, guaranteeing an income for life. While this income is regular and reliable, annuities are inflexible, once bought they cannot be reversed, and cannot be inherited by family. Annuities are closely linked to 15-year gilt yields and, in an era of low rates and yields, annuity rates were correspondingly low. A no-frills annuity bought for £100,000 for a 65-year-old at the time of the 2014 Budget would have produced an income of just over £6,000 per annum.
Dubbed ‘Pension Freedoms’, when the legislation was introduced in the following April, retirees were free to do nearly anything they wanted with their retirement funds, with 25% of withdrawals being tax free, a significant departure from the previous system. Pension funds could now be accessed flexibly by lump sum or via regular income. Retirees had many more investment options and could elect beneficiaries to inherit their pensions after death. Then Pensions Minister Steve Webb courted headlines with his comments that the Government was not overly concerned “if people do get a Lamborghini and end up on the State Pension”. On reflection, one can see his point, a diligent saver is probably unlikely to break the habits of a lifetime on turning 55. Retirees have indeed been sensible and Pension Freedoms have proved to be extremely popular, with over £72bn being flexibly withdrawn since they were introduced. Data from the Financial Conduct Authority shows that more than 205,000 drawdown policies were entered into in 2021/22.
One substantial change was that pensions could now remain invested and reap the benefits of stock market growth and dividends. The FTSE 100 has often been considered fertile ground for income-seekers in retirement, with giant and well-established blue-chip companies in oil and gas, insurance and banking paying regular dividends. Increasing government and corporate bond yields have also recently made a welcome return to retirement income portfolios. Reliability is naturally a large concern for retirees, as regular and sustainable dividends are needed to ensure a stable income. A variety of income strategies can be employed; natural income, whereby capital remains untouched, and dividends are taken as they occur, perhaps with a target in mind, total return, where a set figure in cash or percentage terms is paid out, and where income alone is insufficient, an element of capital is used. Investors could also invest in growth stocks and draw down on capital on the assumption that the portfolio will grow at a faster rate than the drawdown and enjoy an income while maintaining or growing their capital.
Investment funds are also a popular vehicle for income in retirement. While individual shares may pause or reduce dividends, a fund of income generating stocks may provide smoother returns due to the benefit of diversification. Retirement income specialists Chancery Lane looked at the income returned from 32 funds from 1974 and found that income had been returned each year 100% of the time. Additionally, as inflation is a major concern for retirees, they examined the dividend growth of six London listed investment funds against inflation on a five-year rolling basis from 1986 – 2002 and found that dividend growth consistently outpaced inflation over the period.
With retirees no longer obligated to rely on annuities for income, the market unsurprisingly declined. 420,000 policies had been sold in 2012. Ten years later, this figure was down to 68,500. The period of ultra-low interest rates from the 2008 global financial crisis to the resurgence of inflation on the tails of the COVID-19 pandemic, saw depressed yields on government bonds which made annuities less attractive. This trend has recently seen something of a sudden reversal, as interest rates have risen and government bonds offer more tempting yields. The fallout from Liz Truss’ short-lived ‘mini-budget’ in particular saw a large spike in gilt yields, which corresponded to a 12% increase in annuity yields. This recent resurgence meant that 2023 was the best year for annuity sales since the Pension Freedoms reforms were introduced.
Pensions never seem to be out of the news for very long. The run-up to every Budget prompts speculation in the media as to how the Chancellor might tinker with them. The lifetime allowance has been raised, lowered, and then done away with altogether. The minimum pension age seems to be going only one way; ever upwards. Questions are being raised as to the sustainability of the ‘triple lock’ guarantee on the State Pension. While there is much uncertainty, retirees also have more income options than ever before and can save, invest or spend their lifetime’s savings to shape their own unique retirement.
Income Opportunities Across Emerging Markets
Konrad Pietka, Investment Research Team Member
There is no doubt that we live in a multi-faceted world. Some nations are economically well-off, others less so. Some have strong manufacturing sectors, others rely on services for economic output, and many more depend on commodities for growth. Clearly, countries can be grouped into various economic categories. Yet, for investors, the simplest method is to classify them as either one of the Developed Markets (DM) or Emerging Markets (EM). The former receives the majority of investor attention as it comprises of stable, high-income, free-market economies, whereas the latter consists of developing countries with growing but largely cyclical and less established businesses. Consequently, volatility and currency risks are amplified when investing in emerging markets, a deterrent for more cautious investors. Despite this, there are many attractive growth and income opportunities which often go undetected.
To better paint the picture, it is important to consider that last year the emerging market housed 4.3 billion people, accounted for half of global GDP, and was responsible for two thirds of global growth over the past decade. Much of this can be attributed to China, which recorded growth levels reliably above 6% throughout the 21st century so far. However, low consumer confidence, an aftermath of strict COVID-19 lockdowns, an ageing population, and a property crisis have all adversely affected China equities, which on average fell by 13% last year. Even though market gloom and poor sentiment have hit the country, many quality companies remain.
Luzhou Laojiao, for example, is a specialist in the production and distribution of Baijiu, a native liquor. Its annual sales have grown by 20% on average over the last five years, with a net income margin exceeding 40% and a dividend yield of 2.5% to date. Therefore, if the macroeconomic barometer starts moving the other way, there could be a lot of upsides to capitalise on.
Across the Himalayas, sentiment is more favourable in the second-largest EM economy, India. The NIFTY 50, a market cap weighted benchmark index of the country’s 50 largest firms, delivered returns of 93% over a five-year period, outperforming even the S&P 500 by 15%. Demographic tailwinds of a growing middle class and a young, educated workforce, as well as a competitive advantage in the outsourcing industry, are likely to continue propelling growth in the coming years. Although an attractive market in its own right, the growth-tilt in India results in expensive company valuations and limited investment income opportunities, as business profits are predominantly channelled into pipeline projects rather than dividend payouts.
Certain investors may be content with this, especially if their focus is solely on capital appreciation. Nonetheless, the importance of dividends should not be overlooked as they can be indicative of a company’s governance quality. This view is shared by the Guinness Emerging Markets Equity Income team, which only invests in EM companies with high returns on capital and a reliably growing dividend. The rationale is that firms with a focus on shareholder value, financial prudence and sustainable growth are the ones willing and able to incrementally increase dividend payouts. Take a look at Bank Rakyat Indonesia, one of Indonesia’s leading financial service providers. It is a dominant player in the country’s microfinance market, with over 30 million customers, and annual dividend growth of 23% over the past five years.
When seeking to invest in emerging markets, investment funds could be the more appropriate vehicle to use, as opposed to investing in companies directly. By pooling money, funds can invest in a broader range of sectors and companies, diversifying risk, and hopefully stabilising returns. In conjunction with an experienced management team, this should help mitigate the heightened EM volatility risk. In terms of options, these are somewhat restricted, with only ten emerging market equity income funds to choose from. The largest one being the JP Morgan Emerging Markets Income Fund, with a distribution yield of between 3% - 4%. Investors are clearly still warming up to the notion of investing in EM equities for income.
Conversely, the selection of emerging market bond funds is far more extensive. Incidentally, EM hard currency bonds (those denominated in US Dollars) have outperformed their global and Sterling corporate bond peers over both a 10-year and three-year basis, delivering total returns of 56% since 2014, compared to 52% and 27%, respectively. This is due to the higher yields on offer in emerging markets, to compensate investors for the perceived risks.
Emerging market securities can be daunting for some given unfamiliarity with the markets and perceived risks. While operating as a catch-all term, emerging markets encompass several of the world’s largest economies, with strong growth drivers and maturing financial markets that could lead them to become a more common feature of income-focused portfolios going forward.
Multi-sector Credit: Are Bonds Back in Favour?
Samantha Cory, Investment Research Team Member
Fixed-income investments have seen a resurgence in investor attention amid higher interest rates and have been a frequent topic of discussion in recent Redmayne Bentley publications. Having provided poor returns a few years prior, investors are once again enthusiastic about bond markets and the yields on offer. Once limited solely to the secondary market, recent developments with the launching of a new retail access platform by Winterflood Securities is enabling participation by retail investors in gilt auctions, potentially sparking further interest in gilts by individual investors.
When thinking of fixed-income, corporate and government bonds are the first to come to mind, but these are just the tip of the iceberg for a market estimated to be worth US$133tn in 2022. UK investors tend to focus on the domestic Sterling market, limiting themselves to just 3% of the global market. A lack of familiarity, or desire for simplicity, are likely contributing factors, but for those willing to look further afield, their attentions could be turned to multi-sector strategies, similar to the strategic bond funds that are likely to hold a place in client accounts.
Within strategic bond funds and other flexible fixed-income funds, the managers have two strings capable of being pulled in generating returns: interest rate and credit risk exposures. Put simply, they can buy longer or shorter dated bonds to adjust interest rate exposures and higher or lower quality bonds in risk-on or risk-off periods. Mostly limited to government and corporate bonds, these strategies still leave significant parts of the fixed-income market untouched.
Untouched areas of the market include assets such as securitised bonds which, in the simplest terms, are numerous assets pooled into a new legal entity to support a bond issue. One of the most common types of securitised bonds remains mortgage-backed securities (MBS), famously at the centre of the 2008 global financial crisis. Mentioning these investment vehicles can cause alarm bells to ring for some, with torrid memories of the events some sixteen years ago. However, the MBS market has changed significantly, with improving lending standards and a shift to their issuing by government-sponsored enterprises such as Freddie Mac and Fannie Mae. Today, the MBS market in the US remains one of the most traded markets globally, with an estimated market size of US$9.3tn. The structure is easily adaptable to a variety of assets from commercial mortgages, student loans, credit cards and private company loans.
The expected question at this point is why? Why might someone want access to such assets in their portfolios? Diversification is the initial response. With many portfolios’ fixed-income allocations focused on government or corporate bonds, these assets can provide a diversified return stream that potentially lowers risk in a portfolio. Over time, aggregate fixed-income indices have become significantly more interest rate sensitive, as longer-dated bonds were issued to take advantage of lower debt costs. Adding assets with lower interest rate sensitivity can balance holdings in other strategies where more interest rate risk is being taken. A second reason could be valuations-based, with securitised sectors trading well, relative to history, and compared to standard corporate benchmarks where valuations could be argued to be stretched.
This is all well and good, but accessing such asset classes can be tricky for a private individual. Specialist funds in the area are usually limited to institutional investors with significant assets. Buying direct is out of the question, and some significant expertise is required in the area. Luckily, some of the larger asset managers such as PIMCO, the US asset manager with some US$1.8tn of assets under management, hold the solution. Its US$220bn income strategy is well known within the industry, designed to provide smooth through-cycle returns via investment across the fixed-income spectrum and offers an attractive monthly income in the process. The diversified portfolio holds nearly 40% in mortgage-backed securities, 20% in US treasuries and smaller allocations to areas such as commercial mortgages and emerging market bonds.
With gilts still a go-to asset for many, as shown by the UK platforms earlier in this article, investors run the risk of over-concentration in a small area of the global market, potentially missing attractive opportunities elsewhere. A multi-sector bond strategy could be the answer for those looking to diversify and balance portfolio risks.