Investors won’t need reminding that 2020 was a dismal year for income strategies. Yields on fixed income remained pitifully low, while dividends were sliced. This prompted many investors to roam the market looking for alternative sources of yield. However, this too has created problems, with a lot of capital chasing relatively few assets, according to FSA‘s sister publication Portfolio Adviser.
The popularity of alternative income options has been most evident in the investment trust sector, where many are housed. In 2020, existing investment companies in the Renewable Energy Infrastructure sector raised more than £1.3bn ($1.8bn), bringing its total to £7.7bn over the past five years, ahead of any other sector. The strongest individual fund raises were Hipgnosis and Greencoat UK Wind, at £426m and £400m respectively. Investors have been drawn to the combination of strong yields and the ‘green’ theme.
Tower companies have also proved popular. These are part of the digital infrastructure theme. Mobile operators attach their antennae and create their mobile networks. There’s an upfront cost, the anchor tenant pays towards that. Adding extra tenants brings high incremental margin. The income is inflation-linked and exposed to the structural roll-out of 5G. US-based Prologis, for example, has seen its share price almost double from its lows in March 2020. A final noteworthy segment is logistics warehousing – the bright spot within commercial property.
Alternative income vehicles can become ‘difficult’
However, there are increasing concerns among multi-asset managers that valuations for some alternative income assets may look stretched. Ninety One Diversified Income and Cautious Managed funds co-portfolio manager Jason Borbora-Sheen says some infrastructure and renewables investment trusts have seen large inflows.
“There are some small issue sizes, which have attracted significant capital. The shareholder registers are also quite concentrated. For these trusts, when times are relatively good, there can be a low relationship with equity markets and they appear to offer diversification.
“However, 2020 showed lower liquidity and concentration of holding registers can bring about higher correlation to equities during periods of ‘risk off’. It may be that income is maintained, but capital is at greater risk.
“It’s not that investing in infrastructure or renewables is problematic, it’s simply that the vehicles can become more difficult as the cycle moves on.”
Reflation trade has lowered prices
That said, after their strong run in 2020, prices for many of these alternative income options have declined as the reflation trade has taken hold. Greencoat UK Wind, for example, has seen its premium drop from as high as 20% a year ago to around 7% today. The premium for Foresight Solar is also below its long term average. This suggests excitement around some of these alternative income options is ebbing in recent months as concerns over inflation mount. Even though many of these assets have inflation-linked cash flows, their performance can have a relationship with long-term bond yields.
The tower companies have seen a similar phenomenon with many seeing their share prices tread water since November of last year. Borbora-Sheen still holds some of the US tower companies believing they can deliver stronger capital growth as well as secure income. They are also some of the largest holdings in the Gravis Digital Infrastructure Income fund. The logistics warehouses also have a tailwind as supply chains shorten and ecommerce builds traction.
What’s wrong with ‘humble’ equity income?
Even if these options don’t look as inflated as they did, there is still a question over whether traditional equity income may just as good an option.
BMO Gam multi-manager team member Kelly Prior says: “The utopia of diversification can often lead one down far more interesting paths than sticking to the main drag of standard known dividend paying equities. On the one hand there is a premium to be had in backing new ideas, but as the hunt for yield becomes more difficult and we are pushed to take more risk, eventually that income shrinks as the weight of money chasing such assets allows ever cheap funding and ever-increasing competition diminishing returns and opportunity.
“Meanwhile the humble dividend paying equity, starved of capital as we all look to more exciting ways to invest, becomes more efficient. Its share price has fallen through lack of interest meaning its dividend as a percentage of share price increases. There is a lesson here. Never rule out the mundane.”
Borbora-Sheen agrees that there is a lot of pessimism around equity income. He points out that the valuation of equity income indices relative to typical market indices is at near all-time relative lows from a price to earnings point of view. Dividend yield, by contrast, is towards its highs, suggesting a lot of negativity in the price.
Higher inflation and higher bond yields
He also believes that equity income might be the right place to be for an environment of higher inflation and higher bond yields.
“Historically, equity income has displayed sensitivity to bond yields. As bond yields rise, equity income strategies can underperform. That relationship has changed, largely because dividend suspensions and cuts came hand in hand with bond yields falling. Now we’re in a position where bond yields rising is indicative of better economic health and that goes hand in hand with better dividend prospects.”
Nevertheless, this is not to rule out some areas of alternative income. It is difficult to argue against the long-term prospects for renewables, given the backing of global governments for zero carbon targets. Equally, areas such as logistics warehousing are supported by the growth in ecommerce, while digital infrastructure is a necessity. The key is to pay as much attention to the price as the story.
