Finding income generating investments in 2021

The hunt for investment income

2020 was an incredibly challenging year for investors seeking income. In fact, ever since the global financial crisis (GFC) of 2008/2009, generating even a moderate yield has required savers to accept more and more risk for less and less reward.

Unfortunately, the past twelve months has exacerbated this trend. As we look ahead, we can offer some causes for optimism, but the fundamental backdrop of a low-yielding world is not likely to change any time soon.

Cash, in particular, has lost its attraction. For cash to be worth holding, it needs to offer returns above inflation – and this is no longer true. Interest rates and bond yields are stuck in the doldrums, and we don't see any likelihood of this changing in 2021. We discuss the interest rate vs inflation situation in more detail later in this article, and look at the reasons why bond yields are so low. You can also watch the video below.

Are your assets allocated efficiently?

In this current state of play, it makes sense to take a close look at your asset allocation. You may need to discard underperforming cash balances and consider moving more into equities – preferably those which offer yield and the potential for dividend growth. Happily, there are still some attractive opportunities available given the recent share price underperformance of key sectors.

It can sometimes be uncomfortable to feel compelled into a particular course of action, but many investors are being forced to look elsewhere for investment income. TINA – there is no alternative. However, the better news is that we expect 2021 to be a good year for stocks which generate income and offer the prospect of dividend growth.

Our specialists ensure discretionary client portfolios are allocated and diversified effectively. We use our expertise to identify alternative income-producing options, including equity investing, and recommend bottom-up global stocks and funds.

Interest rates are being held down by a debt tsunami

One reason that interest rates and bond yields won’t rise meaningfully in 2021 is that we can’t afford them to. The response to the coronavirus pandemic has been an unprecedented increase in global debt as governments and companies have unleashed a debt tsunami to fund economies, households and businesses through the economic damage caused by lockdowns and societal restrictions.

The Institute of International Finance (IIF) has highlighted that global indebtedness increased by over US$15 trillion in 2020, leaving it poised to exceed US$277 trillion. The phrase 'a trillion' somehow makes the number less concerning; in full, this is US$277,000,000,000,000.

While budget balances are highly likely to improve in 2021, they will still be far from balanced. Meanwhile, the IMF has estimated that the leading G20 countries had “provided around US$11 trillion in necessary support to individuals, businesses and the healthcare sector since the start of the pandemic”.

How can governments reduce their debt?

According to the IIF, debt to GDP was expected to reach 365% by the end of 2020; some 45% higher than its level a year ago. This inevitably leads to the question of how this debt burden might be reduced without triggering a major economic and financial catastrophe. In broad terms, there are three options:

1. Implement austerity so that the borrowing can be repaid
2. Deliver economic growth so that the debt burden to GDP falls
3. Allow inflation to erode the real value of the debt.

Any of these solutions could exacerbate the problems currently being faced by holders of cash and bonds, and none of them is a simple solution.

The first is likely to be political and economic suicide, particularly in the current environment, and may have unintended consequences. Austerity can cause an economy to shrink faster than the debt burden, exacerbating the problem it was put in place to cure.

As far as solution 2 is concerned, sustainable economic growth is not always easy to deliver (just look at Japan’s experience over the last 30 years) and is incompatible with solution 1. Which leaves inflation. In due course, inflation may accelerate, and the response of central banks is likely to be to keep interest rates on hold and allow inflation to rise for a while.

The interest rate story

Looking back to the 1960s, we can see how interest rates – in this case measured by the Bank of England base rate – have fluctuated over time. We can also see that they plunged to near zero from the end of 2008 and have flat-lined ever since.

The next graph shows the Bank of England base rate, but this time we have subtracted the inflation rate. With a reading above zero, interest rates are high enough to protect against inflation; a reading below zero shows that the 'real' value of cash has been eroded.

In the 10 years to September 2020, interest rates have averaged under 0.5%, whereas inflation has averaged over 2%. Cash in the bank has fallen in real terms.

Why interest rates are a key investment theme in 2021

Whatever happens to interest rates in 2021, it is inconceivable that interest rates in the UK and most developed nations will rise meaningfully in the short to medium term. In fact, there are valid reasons why interest rates could actually fall further in some countries.

Even if interest rates aren’t cut again, it would be an economic catastrophe if borrowing costs were raised in most countries. Interest rates will only rise if growth accelerates so much that the danger of further economic retrenchment is over, or inflation increases so much that to leave it unchecked would threaten financial stability. Both conditions are nowhere near being met; in fact, the US Federal Reserve has softened its approach to inflation, shifting to an 'average' inflation target that allows for periods of higher inflation to support the economy’s recovery.

High inflation is usually driven by excess demand – too much money chasing too few goods. It is difficult to envisage this particular problem emerging any time soon, even if there is some pent-up demand waiting on the sidelines. In short, the current situation of interest rates running below inflation is unlikely to change in the near term; if anything, the relationship could deteriorate further.

If cash is no longer king, where should investors look for an income-bearing investment?

Equity-based investments

The value of stocks and shares fluctuates, often significantly, and any dividend stream is not guaranteed and will change (albeit hopefully grow) from year to year. That aside, equities are one of the few assets which currently offer a yield above inflation. This can be seen by looking at the dividend yield of the FTSE All-Share relative to CPI.

While short-term volatility can be unsettling, share prices tend to move in line with company earnings over the long term, as demonstrated below. In this instance, we have used the US stock market, given its status as the largest and most liquid of the world’s equity markets.

Many companies have been forced, or elected, to cut their dividend in 2020. However, there have been such instances in the past and the long-term correlation between equity prices and company profits can reasonably be expected to feed through to higher pay-outs over the medium to long term. Between 1997 and 2019, the dividend per share of the FTSE All-Share rose by an average 6.6% per annum.

While the yield on cash and bonds falls as interest rates decline, there is clear evidence that the capital value of equity markets responds positively to low interest rates. Meanwhile, the dividend yield from the UK equity market stood at 3.5% in November 2020, far in excess of cash and government bonds and, crucially, above the UK’s 0.5% year on year rise in CPI inflation. Investors are at least being offered some compensation for the risk of investment.

Experience would suggest that corporate profits and dividends will recover more quickly than interest rates will rise. Indeed, it is almost a prerequisite, as there is little chance the Bank of England and other central banks would countenance higher borrowing costs until there is clear evidence of a corporate recovery. That recovery will be in the form of higher profits and an expected rebound in dividend payments.

The importance of choosing the right stocks and sectors

Those who are worried they might have missed out because of the sharp rally in stock markets since the depths of the lows in March 2020, shouldn’t be overly concerned. In absolute terms, higher yielding parts of the UK equity market were still cheaper at the end of 2020 than they were at the beginning of the year. This was also true of many global stocks. Meanwhile, the UK equity market itself significantly underperformed overseas markets, so hunters for investment income might want to consider looking at the UK.

Dividend-paying stocks have fared badly compared with the broader market. To show this, the graph below splits the returns of global stock markets into various factors. The best companies in share price terms during 2020 were those that demonstrated sales growth, high volatility and momentum. At the other end of the spectrum, value stocks and stocks which paid a high dividend lagged behind.

However, this hasn’t just been a year-to-date phenomenon. Compared with the share prices of their broader equivalents, the dividend-yielding parts of equity markets have underperformed for the past five years.

In the graph below we have compared the FTSE UK Dividend+ Index with the FTSE All-Share, and the FTSE All-World High Dividend Yield Index with the broader market. In both cases, there has been marked and prolonged underperformance.

Much of this underperformance can be explained by the sector composition – what the dividend yielding indices own and what they don’t own. As far as the FTSE UK Dividend+ Index is concerned, it has a weighting of just 6.5% to technology, which has been in vogue with the investment community, while over 35% of the index is comprised of financials which have been out of favour.

Buying into bank stocks

Financial stocks have suffered general underperformance and it is true that many financial institutions either elected to withhold dividends in 2020, or were forced to by their regulator. When COVID-19 spread through Europe and the US in the spring, global regulators effectively banned dividends to ensure banks retained sufficient capital to continue lending to struggling companies.

In the first half of 2020, large western banks booked over US$139bn in reserves to cover their potential loan losses; this was the highest level since the nadir of the financial crisis in 2009. However, after countries relaxed their rules over the summer, a sharp drop in provisions resulted in many lenders’ capital cushions growing at a rate far in excess of supervisory minimums. 

Bank shareholders have become increasingly vocal in their demand for companies to be allowed to restart dividends or repurchase stock, with countries such as Switzerland and Sweden already indicating that payouts could resume in 2021. While the US Federal Reserve, European Central Bank and Bank of England have yet to make a decision, it would be a surprise it they weren’t allowed to, predicated on the gradual roll-out of a coronavirus vaccine and a continuing return to economic normality. 

In an environment of income scarcity, where the fears for the financial environment have moderated, it is easy to envisage a scenario where a resumption in bank dividends is met with an extremely positive share price reaction.

Take a look at the UK equity market

Meanwhile, the UK equity market looks cheap relative to its global peers, and it is both under-owned and out of favour. As the world increasingly returns to 'normal' in 2021 this underperformance is likely to begin to reverse, with dividend-paying stocks in particular being in greater demand.

In the final reckoning, the dividends from the UK market will likely be reduced by 40% - 50% in 2020, compared to 2019. However, active fund managers will be able to mitigate some of these effects and to all intents and purposes this is now last year’s story.

Currently, there is a great deal of cash sitting on the sidelines earning little or no income. We believe a meaningful proportion of this will surely make its way into the traditionally higher-yield UK market once some of the uncertainties of the past few years melt away. Many dividends which were cut or eliminated are likely to be reinstated or raised in 2021, which is why we believe this is an important investment theme.

As one prominent UK fund manager has remarked “The UK market might be the land that time forgot, but the best time to invest can be when it feels most uncomfortable. As we emerge slowly from the ongoing pandemic crisis, UK equities are poised to deliver on what is the best opportunity for this asset class since the global financial crisis.”

Investments to consider avoiding

Like cash, government bonds were once a viable option for investors seeking a potentially higher return than cash, but still with a low risk profile. Here again, the yield has fallen significantly, and is unlikely to rise meaningfully in the current environment.

The chart below shows the yield of 10-year UK government gilt, which is currently below inflation, making a negative real return the likely outcome. Shorter dated issues offer an even worse return profile, with investors losing money in both nominal and real terms. The same issue affects debt issued in the euro area, Japan and the US to a greater or lesser extent.

Yields for both investment grade and sub-investment grade (otherwise known as junk) bonds have also fallen significantly; the yield on US corporate high yield issues fell to its lowest ever level during November 2020.

The blame for this downward pressure on interest rates and bond yields falls squarely on central banks, thanks to their policy of reducing interest rates and buying vast amounts of government debt. 

This has distorted bond markets across the credit and maturity spectrum. Quantitative easing programmes re-accelerated during the coronavirus pandemic, the range of issues purchased was expanded, and bond yields have fallen further.

Be warned – always consider the risk and reward trade-off

Comparing cash with other opportunities is like comparing apples with pears. The ultimate no-risk investment (assuming a deposit with a reputable, regulated entity, fully covered by a deposit protection scheme) is cash. Other investments offer different risk and return trade-offs, with the overriding principle that a potentially higher return involves a higher level of risk. There is no such thing as a free lunch, and an allocation to cash and low risk investments should always be considered as part of a balanced portfolio strategy.

In conclusion: making the right choices for your individual needs

For investors desiring income who are holding cash, the real value is diminishing over time. The same problem faces holders of highly rated bond issues, but moving lower down the quality curve has meant taking more and more risk for less and less yield.

If the fact that inflation is winning the battle with interest rates and bond yields is a concern, then investing some of this balance – according to individual circumstances – may be the best option available. Even a move toward corporate rather than government debt will offer some increase in yield, although it still may not offset inflation unless it's balanced by a meaningful level of capital risk. There are also arguments that the corporate bond sector is not rewarding investors enough for the risks they take.

Equity-based investments offer a range of options – including real estate investment trusts, individual companies with an unbroken track record of dividend pay-outs and dividend growth, open-ended equity income funds, and infrastructure-related assets. There is more than enough choice to satisfy almost any taste. Income-oriented investors should consider equity for at least part of any excess cash balances for the foreseeable future.

How can we help?

If you have a discretionary portfolio with Canaccord Genuity, our experts will be delighted to take a look at your current cash holdings and help you decide whether a change of allocation would benefit you. If you would like to talk to us about your portfolio, please get in touch with us or email wealthmanager@canaccord.com.

Read our other 2021 investment themes:

• Politically motivated – how politics and investments work together
• How COVID-19 is impacting the world of investment
• Just too big? Will the technology titans hit a wall of regulation in 2021?