Lloyds Banking Group (LLOY)

 

Five ways to harvest sustainable UK income

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Five ways to harvest sustainable UK income

Since the financial crisis, investors and savers have seen meagre yields from cash and gilts, with rates anchored at historic lows.

For investors accessing markets to extract additional income, it is more important than ever to navigate stretched valuations across many asset classes.

Furthermore, investors must carefully consider the sustainability of income generated from equity and fixed interest investments.

Despite mounting doom and gloom over the UK economy, the outlook for dividends remains sound, recently buoyed by the rapid pound depreciation, which has benefitted overseas earners.

Investors should remain wary of dividend concentration, but the UK will continue to be a strong and reliable long-term source of income.

Taking a long-term, value-driven approach, here are five income opportunities in equity and fixed interest markets:

Value opportunities in unrated gems

We have maintained a large exposure to unrated and subordinated debt, mostly in the form of preference shares and Permanent Interest Bearing Shares (PIBS).

Just because these types of instruments don't have a credit rating, does not make them low quality.

There are plenty of companies which have taken the decision not to pay for a credit rating and are considered robust businesses - John Lewis is a good example.

Insurance company preference shares are a neglected and under-researched area of the market. It is permanent capital for these companies and can provide a rich seam of value and additional yield - for example Royal Sun Alliance, Aviva and General Accident.

Separating the casino from the utility in UK banks

We carried a large underweight to UK banks since the crisis. UK banks entered the financial crisis with very low capital ratios, found dubious ways of complying with Basel III requirements and were, by and large, an ethics-free zone.

Furthermore, many banks continue to be encumbered with high-risk investment banking operations. When investing in banks, it is important to separate the casino from the utility.

A decade on, we have seen positive developments among some UK banks, in terms of restructuring and regulatory scrutiny.

Following a period of close analysis, we recently took a position in Lloyds (LLOY) - our first domestic UK bank since the crisis. It is a relatively low-risk bank, with 95% of its lending book exposed to the UK and a 25% share of the UK's current account market.

Lloyds is also trading at a historic low - well under half of its pre-crisis share price.

Rock-solid insurance companies

Most of our financial exposure is in insurance, where solvency ratios have been rock solid. While low interest rates are a drag on performance, we can expect this to turn into a tailwind when rates slowly lift. Strong names in this space include General Accident and Legal & General (LGEN).

Strong real yields in commercial property

Commercial property also looks solid value. Since the crisis we have seen low levels of property development and vacancy levels remain close to record-low levels. Yields are a very robust 4.5-5%, while rental growth remains positive driven by strong tenant demand.

Property rents tend to keep pace with GDP growth over the long-term, so it can be argued this is a 4.5-5% real yield.

Picton Property (PCTN) and Londonmetric Property (LMP) are great ways to gain exposure to this asset class.

Look to Asia's growth engine

China looms large in the Asia region and for good reason - it is Asia's growth engine. Every few years we hear a scare story about China - the currency devaluation being the latest - but its economy remains resilient.

The service sector is faring well and consumer sentiment is strong. GDP growth of 6-8% looks achievable to support a more balanced and transitioning economy. While the obvious cheapness has evaporated, Asia remains attractive on a relative global basis.

We are currently invested in the region through HSBC (HSBA), which earns most of its profits in Asia - as well as local companies such as dominant telecom China Mobile (CHL). Both yield more than 5%.

Robin Hepworth is manager of the EdenTree Higher Income Fund.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.