The hare and the tortoise: is inflation outrunning your clients’ income investments?

The last two years have been dominated by inflation and rising interest rates. Whilst this has challenged the performance of some asset classes, both dividends and bond yields are higher, which makes the case for high yielding investments compelling.   

An income investor will obviously want to outrun inflation and maintain their spending power. Failure to do so is a risk, arguably a foreseeable harm under Consumer Duty, and one they will likely want to avoid.

We find for investors who use income to supplement their lifestyle, or those at retirement, there are contrasting considerations: income is higher, but so is inflation. This poses two questions:

1. How to deliver positive outcomes
2. What value can an income portfolio provide?

Begin the race with the end in mind

Investing with an income mindset cannot ignore the caustic effect of inflation. An appropriate strategy that sets out to keep pace with, or outrun inflation, can beat the hare over time. To mitigate inflation needs to keep pace with inflation. If your invested capital grows at 3.5%, ahead of inflation, and your income holds steady at, say, 4%, then your income will keep pace.

The other element is time and whilst we have seen a short-term spike in inflation, there are early indications that it is falling. So with any investment strategy the income and capital need a level of consistency to achieve the desired outcomes.

We can clearly see there are two return elements here – capital performance and income – a key mindset difference: income investing is not purely about one outcome.

Maintain a steady pace to win the race

Equity dividends have continued their recovery after the pandemic, and high commodity prices and interest rates have improved dividend payments from companies especially with exposure to energy, financials and mining markets.  

There is evidence that dividends can, and often do, keep pace with inflation in the long run. Companies that have the ability to increase profits at or above the rate of inflation, can raise their dividends. Therefore a portfolio with a meaningful amount of equity exposure, in the appropriate proportions, will have the potential to beat inflation. 

The UK markets have been a prime beneficiary of better dividends. Dividends keeping pace with inflation is positive, but too much focus on one region can unravel, especially if specific industries have a change in prospects.

To win the dividend race, risk management is paramount in three areas. 

1. Firstly, not investing too much in one region or an underlying asset class will help. Diversify, diversify, diversify.
2. Second, buy the appropriate funds. Active funds can adjust their investments to deliver higher income, so it makes sense to invest in funds that deliver higher dividends.
3. Third, understand the ability to continue to raise dividends or any other form of income. To improve dividends, profits need to rise, or there needs to be the appropriate dividend cover. Using powerful software that gives an investor the ability to ‘see’ through to the underlying data and the ability to pay dividends is a very useful insight tool, one that isn't available to everyone.

Defensive investment has a place in the pacing strategy

Dividends have rushed ahead but what if there is a pause? Maybe higher rates reduce profits and dividends, or inflation crimps profits. Other asset classes can combine to deliver the income outcome.

Bond yields remain enticingly high and could remain high for a little while yet. Prices of these investments have fallen so there are opportunities in both price and income from bond markets and defensive assets.

The key is to be able to adapt the risk in a portfolio to diversify but take advantage of opportunities.  Yields on government debt are now attractive and funds that have exposure to government debt will hold some attraction for both yield and capital growth.

Active fund managers should play a role in fixed income. They can help mitigate risks – and avoid companies like Thames Water, or the now defunct Silicon Valley Bank – but also see if the companies can cover the interest on their bonds.

Different tortoises need their own pacing strategies

Not all tortoises are the same and, like your clients, they will need a different pacing strategy for both income and capital. An interest in possession trust will have a different requirement to a wealthy individual at retirement. The former may need more growth than income, and the latter a greater focus on diversified natural income. The option to adjust the ‘pace’ of growth and capital can help win the race.

How can  FE Investments help?

At FE Investments we can help your clients win the race and beat inflation. We partner with advisers to help deliver discretionary managed portfolio solutions to their clients. Our Natural Income portfolio range is designed to address the issues mentioned above; the portfolios cover 5 different outcomes for investors in terms of growth and income. They are outcome focused which differentiates the portfolios from other UK-centric solutions. The investment process leverages our heritage in software and data and affords the ability to analyse income, and also the underlying risks to dividends and bond income. Diversification and risk management are the cornerstones of our investment process, helping maximise the success potential of positive outcomes.

Important information

This is a marketing communication, intended for financial advisers only. Not for use by retail investors. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. The value of investments and the income from them may go down as well as up and you may not get back the amount originally invested.

All information is correct as at 19/07/2023 unless otherwise stated. Where individuals or FE Investments Ltd have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.