Six income ideas for your portfolio

Government bonds look increasingly poor value, but you can still earn a good income from more specialist investment opportunities, says Jon Rebak.

Many investors are increasingly wary of the bond market, especially government bonds. I am certainly in this camp as I own none of them directly, and haven’t for the last three years. They appear to offer little or no intrinsic value. Over time, governments of any colour tend to be poor custodians of the value of money, so unless you receive adequate compensation, you shouldn’t lend to them.

However, I’m still interested in other income assets that trade at a reasonable price and where demand should remain strong in future. There are a number of more specialist areas of the market that offer respectable prospects over the next few years.

What I’m looking for are situations where there is a decent level of yield, an eye to protecting investors against potential risks, structurally defensive operational characteristics, a technically interesting situation or good management. Some of these investments can appear dull, but may work well as part of a diversified portfolio, especially if your time horizon is long enough (I have a holding period of at least three years in mind).

Build a diversified portfolio

The key is to look for a range of different strategies that have varying sensitivities to interest rates and inflation, and also some idiosyncratic features. There are a wide range of sectors in which it’s possible to invest, including high-yield bonds, mortgages, ground rents, floating rate notes, infrastructure, student property, asset leasing, convertible bonds, peer-to-peer lending, or perhaps catastrophe bonds. These tend not to move as one (unless there’s a Brexit-type political event or an exogenous economic shock) and so are ideal for building a diversified portfolio.

Investment trusts are often a good way to invest in these sectors, since their closed-end structures are well suited to illiquid, long-term investments. In addition, trusts typically provide good disclosure on their holdings, making it easier to analyse the nature of their underlying portfolio. That said, investors should take great care with regard to the timing of their investments, be aware that liquidity in some of these trusts can be low, and pay close attention to news flow and related corporate actions. Below are six of the trusts and other listed funds I like at the moment. An equally weighted portfolio of the following ideas would deliver an average yield of 5.4% today.

Two interesting bond funds

Henderson Diversified Income (LSE: HDIV) invests across a broad spectrum of secured loans, investment-grade bonds and high-yield corporate bonds, with a bias to European and UK issuers. The primary risk is that borrowers will default on their obligations, although the portfolio is more defensively positioned than it was a year ago and the managers are wary of holding industrial and cyclical sectors. The trust is trading at a modest premium to net asset value (NAV), has gearing of 19% and a dividend yield of 5.5%. The managers expect returns over the next year to be broadly in line with the coupon, so capital appreciation prospects are likely to be limited.

The risks here are twofold. First, European politics could cause some upsets in credit markets. Second, a severe global recession would be likely to lead to a sell-off. However, investors can take comfort that we have not seen the business cycle excesses in recent years that are usually the seeds of a major default cycle.

The NB Global Floating Rate Income Fund (LSE: NBLS), managed by Neuberger Berman, invests in a global portfolio of below-investment-grade senior secured corporate loans, diversified by both borrower and industry with around 300 individual holdings, predominately in US issuance. The trust is trading close to NAV and offers an attractive yield of 4.2%. Credit-market jitters almost inevitably result in funds such as this coming under pressure from investors, but there is some protection against default risk, as loans are typically secured and rank higher in the capital structure. The portfolio is hedged to sterling, so there is no exchange-rate risk. Gradual interest rate rises should be beneficial for the floating rate loan market, since the rates paid by existing loans will rise in response (unlike fixed-rate bonds and loans), and so this fund’s share price might rise ahead of NAV in these circumstances.

Buy into student digs

There are several listed asset-backed funds available, including Empiric Student Property (LSE: ESP), which invests in modern, high-end student accommodation and aims to provide shareholders with rising dividends and capital appreciation. It has a target to manage 10,000 beds across 25-30 cities in the UK. I’ve been impressed by its progress with new developments, and with up-and-running projects where it hopes to add value through active operational management. There is a focus on the international student market, and so there was disquiet around the time of the Brexit vote. I suspect this is still a source of concern in the market, but this fear is overdone: after all, a weaker pound has made a UK university education cheaper for those coming from abroad. The running yield is 5.6%, based on last year’s distribution, while the shares are trading slightly above reported NAV. Results are due soon and I’d expect to see a modest uplift to NAV.

UK Mortgages Limited (LSE: UKML) is managed by TwentyFour Asset Management, a fixed-income specialist manager based in London. The fund invests in a diversified portfolio of UK buy-to-let and private residential mortgages, and aims to enhance returns through leveraging up the portfolio. The fund launched in 2015, but has taken longer than expected to become fully invested and this has held progress back. However, this is a very long-term product, which involves credit analysis, modelling, pricing, negotiation, operational due diligence and third-party financing, and so the process has not been easy.

In addition, this is a highly competitive market and the team has been very selective in only investing in the best-quality opportunities. The good news is that terms to invest the remaining capital have just been agreed. The degree of leverage is the main risk for investors, but the internal rate of return on the leveraged portfolio is in excess of 8%, so the trust’s current yield of 6.1% appears well covered. The shares are trading at premium of 2.5% to NAV, including accrued income, which is not excessive in the current environment.

When the JP Morgan Global Convertibles Income Fund (LSE: JGCI) launched in 2013, it traded at a premium to NAV. But since 2015 a discount to NAV opened up and has settled at the current range of about 8%-10%. The trust invests in a global portfolio of convertible bonds (diversified by quality and sector), hedged to sterling. When I started looking, the trust had a low delta (which is a measure of the sensitivity of its value to the underlying equity of the companies it holds) of about 20%, but this has risen to 30% recently. That may help close the discount to NAV in future, since the trend in the NAV has been steady to slightly positive. The yield is currently 4.9%, which is reasonable for a strategy that can still to an extent benefit from rising share prices, has low duration (a measure of sensitivity to interest-rate changes) and overall has a defensive profile. I would place this investment in the “dull but worthy” camp, which is no bad thing.

A premium worth paying

My final idea comes from the more esoteric end of the market. SQN Asset Finance Income Fund (LSE: SQN) is the only diversified equipment leasing and asset finance investment company traded on the London Stock Exchange. The fund aims to generate regular income through collateralised investments in business-essential equipment and hard assets, and in asset-and-equipment-based project financings.

The company has experienced management in the trade and invests in specialist segments of the market, such as waste treatment, heating equipment, industrial painting equipment and anaerobic digestion plants. Leasing can be a highly predictable cash-generative business and so far SQN Asset Finance has delivered on expectations since launch. The half-yearly report just issued indicates the weighted average portfolio yield is 9.8%, which in turn has driven the monthly distribution equivalent to 7.3% of net assets.

However, because this is a great business to be in, and because returns on the underlying portfolio have a low correlation with equities, the shares trade at a 14% premium to NAV, meaning that the yield for investors now falls to 6.3%. Some may balk at paying such a premium, but I think in this situation it is still worth considering.

Merryn

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