Building suitable income portfolios
When building suitable portfolios for income-seeking clients, it is important to maximise diversification, rely on natural yield (especially from mid-risk assets), and adopt a dynamic asset allocation approach.
A well-diversified portfolio should hold a combination of bonds, equities and alternative assets such as property and infrastructure.
Historically, bonds were the main income-generating asset within income portfolios. Coupons from high-quality bond issuers such as governments and investment-grade companies can provide a stable source of income for investors.
A multi-decade decline in inflation, however, caused a fall in bond yields, limiting their role for income generation.
Last year was a watershed moment for bond investors as a sustained rise in inflation after the pandemic was met with commodity price pressure due to the war in Ukraine.
Central banks and investors were caught napping and bond prices saw their sharpest decline in three decades. Bond yields rose sharply, making bonds extremely attractive for income-seeking clients once again.
The rise in bond yields was accompanied by severe tightening of monetary conditions. Economic growth has slowed, and inflation has started to recede. This creates a favourable backdrop for bonds to rally. Bonds with longer maturities or duration stand to benefit more if these trends continue.
Equities have historically been riskier than high-quality bonds but do provide better protection against inflation. This is because earnings can adjust to rising inflation. Many investors turned to equity markets to generate the income they required. While they are attractive sources of income, volatility and lack of growth in income-generating sectors creates a risk for income-focused equity investors.
When seeking equity allocations for income generation, it is important not to target too high a yield and allocate to quality, value and growth companies.
Quality companies have high and stable margins, pricing power and little sensitivity to the ups and downs of the economy. These companies tend to have limited competition and large “moats”.
Moats are a company’s ability to protect its market share. Unilever for example has a wide moat due to branding and scale advantages.
While moats can shrink over time, understanding what makes a company’s revenues defensible is an excellent way to understand what to worry about. Quality stocks are an excellent source of dividend income. These stocks should form the bulk of an income-generating equity portfolio.
Value companies require a lot of capital (miners, banks, industrials) and have highly variable margins. They are sensitive to the economy and will therefore at times become highly risky. While they can have large dividends, these dividends are likely to be cut if the company’s profits shrink too far.
