The return of income – a season of plenty

Next year will herald a “new paradigm” for investors where income once again becomes a focus of thought, according to the global head of institutional investments at Fidelity International, Michael Gordon.

Yields for investment grade bonds, UK (and other) property and equities are at historical highs, he says in a note to clients looking at the likely scenario for 2009.

Gordon, who is based in London but whose brief covers the world ex-US, says: “It seems odd to talk of income as something new as it has, for long periods of market history, been a dominant consideration for investors. Income has historically been the principal contributor to total investment return, even in equity markets.”

Over the 108 years from 1899 to 2007, the reinvestment of dividend income accounted for almost all the total return from the UK stock market. An investment of $100 at the beginning of the period would have grown to just $13,580 in capital terms but to $1.64 million with gross income reinvested, according to an Equity Gilt Study by Barclays Capital.

Gordon says: “Day by day this is disguised by investors” focus on fluctuating revenue and earnings. A company’s income stream is a more stable source of value, or should be, but it has not been prized as such. Both the level of income available as well as its security is something investors haven’t focussed on sufficiently in recent weeks, as the market turmoil has thrown up a number of opportunities.

“If investors do believe that income is what should be sought, this Christmas could indeed be a time of joy. Income abounds at present. Investment grade and high-yield bonds offer yields at historic highs. UK property is currently yielding 200-300bps premium to 10-year UK government bonds. This is at a time when inflation is falling fast, so the real returns are immense. Yields for investment grade paper and property look appealing, particularly as cash rates have plummeted and are going to fall further.

“The environment is difficult, to be sure, but there is good evidence that firms have strong cash-flow support to be able to pay this income. Net interest payments currently represent less than 10 per cent of cashflows on average in the US. Back in the early 1980s this measure was between 25 per cent and 30 per cent. High-yield spreads are extreme and funds are offering yields in excess of 20 per cent.

“In equity markets too, dividend yields are attractive, even if the waters have been muddied by the conditions governments have placed on dividend policy as a quid pro quo for the injection of taxpayer capital into bank balance sheets. There are three dividend yields that investors can study right now – historic, current and future. The first should be disregarded.

The same with the second as this is an exceptional time of temporary dividend holidays for some companies such as the banks although, significantly, on October 19 the yield on the S&P 500 crossed the yield on the US 10-year treasury bond. An income opportunity for equity income was presented that had not been seen for over 50 years apparently.

“But it is the longer-term future level of equity dividends that is of interest and this will likely settle at a level somewhere between the historic and current figures. Futures markets indicate that a fall in European dividend payouts of 50 per cent is expected. In the US that number is a little less than 25 per cent. I suspect that investors will feel comforted when they see that their future expected dividend yield will be at least 1.5 to 2 percentage points higher than the cash rate.

“So, why are these opportunities so great at the moment? The answer is two-fold. The first is a lack of free capital. More capital is demanded by the deleveraging process. Without the support of sufficient free capital a pervasive sense of fear has dominated in today’s markets. Undercapitalisation was a key theme of the past few years. It is in reverse now. But, on the other hand, there is ample liquidity being created by governments and their independent central banks.”