Hunting for quality income

Hunting for quality income

Both short- and long-term interest rates have risen sharply in the majority of countries since the beginning of the year. At the same time, global stock, bond and credit markets have suffered double-digit declines.  Consequently, long-term investors can choose from a much more varied range of attractive income-bearing assets than in 2021.

Today, we see long-term value at moderate risk for income-seeking investors in three specific areas despite global economic growth slowing: i) US investment-grade corporate bonds, ii) global high dividend yielding stocks and iii) public and private infrastructure funds. 

OUR RECOMMENDATIONS

This investment theme includes potential exposure to corporate bonds, dividend-yielding stocks as well as public and private infrastructure funds.

We favour:

• US investment-grade corporate bonds, funds and ETFs;
• Global quality dividend stocks, funds and ETFs;
• Share buyback ETFs;
• Private and publicly-listed infrastructure funds and ETFs

KEY RISKS

A prolonged global economic recession is the principal risk to this theme, as it could result in rising corporate bond default rates and cuts to stock dividends.

A prolonged period of stagflation (low/zero growth combined with high inflation rates) would also challenge this investment theme, as it is typically an unfavourable economic environment for both stock and credit markets.

A recovery in the EUR/USD exchange rate in favour of a stronger euro could impact returns for euro investors in US corporate bonds – we would thus favour currency-hedged US corporate bond funds and ETFs for euro-based investors in order to minimise this risk.

US corporate credit now offer tempting yields

Today, we see three ways to gain income from the corporate world. Firstly, defensively-oriented investors may wish to look at investment grade corporate bonds. Credit spreads have widened since the start of 2022, pushing corporate bond yields up to levels not seen since 2009. We prefer US corporate credit over Europe, given lower economic risks and higher yields.

Investing in high dividend stocks

More dynamic investors can consider stocks with high dividend yields. This factor underperformed the broader market during the rally from the COVID-19 lows in March 2020. When growth is solid and inflation modest, dividends are of less importance as investors then prefer to invest in growth stocks. However, during times of high inflation this focus changes. Dividends are ultimately a function of revenues and profits. When inflation goes up, revenues tend to rise in conjunction with higher prices for goods and services. High dividend stocks backed by solid cash flows should thus outperform in today’s macroeconomic environment.

We prefer a high dividend approach that also includes certain quality characteristics. Over the long term, this combination has outperformed both the broader market and pure unfiltered high dividend strategies.

A quality dividend approach wins over time

Avoiding dividend value traps. The capacity of a company to pay a dividend is vastly driven by its current profitability. Therefore investors may be well advised not to make the mistake of focusing solely on historical dividend payouts. A very costly mistake can in fact be to estimate the dividend yield based on the latest payout. The yield may be artificially inflated by a low share price, which itself could be a indicator of fundamental problems in the company. Thus, a purely high yield-focused investor may end up seeing the expected dividend cut, on top of a falling share price.

Hence, we prefer a quality dividend approach which takes into account the future capability of a company to maintain and grow its dividend payments over time. Quality companies tend to produce more stable cash flows over time, thus supporting stable dividend payouts.

While the dividend yield of a quality income strategy may not be as high as for a pure high yield product, the quality approach helps the strategy to perform well in different market environments. We believe that quality dividend solutions are an attractive way of obtaining a more defensive equity exposure in a high inflation environment.

Infrastructure assets for income growth

Infrastructure is a third asset class to consider for long-term stable income growth. Infrastructure funds include diversified exposure to a range of steady real income-generating assets, including transport (motorways, rail, ports, airports), energy (oil & gas pipelines, electricity and gas supply grids), water utility providers, social (hospitals, health clinics) and technology/telecoms (mobile phone masts, datacentres).

Long-term performance of listed and private infrastructure funds has been impressive, with the Dow Jones Brookfield Global Infrastructure index delivering a 10.8% annualised return since 2003, outperforming stocks and bonds. Given strong underlying demand, we see this trend continuing.