The spectre of further market volatility haunts investors as they look for income

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Allan Lane, Algo-Chain

After the mother of all market selloffs in March and the mother of all market rebounds in April, it is long overdue to survey the debris that some investors might mistake for a well-constructed portfolio. As an income investor one should really ‘beware the Ides of March’ and in this article I will review four sources of income and the risks that come with that territory.

Occasionally I get asked to make an MP3 file of old vinyl records that I have, with the intention of selling one to buy another, much like re-balancing my portfolio you could say.  Imagine my surprise recently when having made a three-minute recording, on playing it back I noticed that the needle got stuck after the first minute and repeated itself for about 15 seconds and then carried on as normal.  When it comes to the topic of income investing, then it would be fair to categorise the topic as sounding like a broken record.

In a world where the S&P 500 Index was down 12.5 per cent in March in USD terms but went on to rebound by 12.7 per cent in April, one is reminded of the textbook topic of hysteresis economics – where future unemployment levels and international trade are severely impaired even though the markets have bounced back.  As for being able to identify funds that will deliver a reasonable level of income, the market crash has re-set the opportunities in the hunt for yield.

Fortunately, ETFs provide a very convenient investment vehicle to make side by side comparisons when selecting funds for a portfolio as most asset and sub-asset classes are accessible as an ETF index tracker.    Here I focus on four ETFs that are listed on the London Stock Exchange and provide what might be above average dividend yields.

Management Fee: 0.07 per cent per year
London Stock Exchange Ticker: HUKX
Trading Currency: GBP
Dividend Frequency: Semi-Annual
Distribution Yield as of 30 June 2020: 5.84 per cent

Over the years the FTSE 100 Index has always been a good candidate for income, which combined with the fact that over the last three months on a relative basis, the UK equity market has underperformed within its peer group, the current implied distribution yield is looking very promising.

Like anything that looks too good to be true, there is a catch – the UK is facing severe headwinds as it makes the transition from a ‘furloughed’ economy to one that needs to be self-sufficient.  Will the stocks that comprise the index be able to maintain their dividend?  The good news is that as an index including a large percentage of international firms, it’s not all about the UK economy but it does make the risks even harder to assess.

Note, most ETF factsheets define the distribution yield as the total dividend payment one would receive per share over a one-year period divided by the NAV on the date in question. Uncertainties around dividend yields for the next year are in both the NAV level and the size of dividends that are paid over the next year. An interesting feature with ETFs is that dividend payments from individual companies are accrued in the fund until they are being paid out by the ETF provider on a usually quarterly, semi-annual or annual basis. This HSBC fund will pay its next dividend in August, by which time the dividend yield is expected to be down as some UK companies have reduced or suspended their dividend payments.

Xtrackers MSCI Nordic Index UCITS ETF
Management Fee: 0.30 per cent per year
London Stock Exchange Ticker: XDN0
Trading Currency: EUR
Dividend Frequency: Annual
Distribution Yield as of 30 June 2020: 4.83 per cent

Given we have all seen the headlines how the Nordics region has been able to fend off the worst impact of the Covid-19 pandemic, it’s encouraging to see this has been reflected on the pronounced recovery of the returns delivered by this Xtrackers ETF.

Historically some countries within this region have been coupled to the waxing and waning of the oil markets, but looking at the index, this is certainly not the case.   Industrials are the biggest segment accounting for 25 per cent of the exposure, and with energy stocks having a weight of 4 per cent, this shows a 70 per cent exposure to the Healthcare, Financial, Consumer Staples and other sectors.   As a GBP investor though, the issue of currency risk looms large as the UK enters a very difficult period as the presiding government unofficially appears to be aiming for a hard Brexit which will not help Sterling.

iShares $ High Yield Corp Bond UCITS ETF
Management Fee: 0.50 per cent per year
London Stock Exchange Ticker: SHYU
Trading Currency: GBP
Dividend Frequency: Semi-Annual
Distribution Yield as of 30 June 2020: 5.62 per cent

Income from a fund earned as a dividend payment always runs the risk that the companies in the spotlight may not maintain the same level of pay out going forward.  Fortunately, that is not the case with Fixed Income products, which by their very nature do pay a coupon amount that is published in advance.  The only real problem here though is that the Bond issuers need to be around to make those payments.

Welcome to the world of High Yield Bond funds where the proposition is very simple to take on board – if you want a higher return on your investment then you need to take on counterparty credit risk.  After the recent sell-off the optics look very attractive in the high yield space.  Invariably these products are denominated in USD and come with currency risk, but as more and more ETF issuers do offer GBP hedged share classes, this risk can be addressed.

WisdomTree AT1 CoCo Bond UCITS ETF - GBP Hedged
Management Fee: 0.50 per cent per year
London Stock Exchange Ticker: COGO
Trading Currency: GBP
Dividend Frequency: Semi-Annual
Distribution Yield as of 30 June 2020: 5.74 per cent

Finally, we look at the very innovative CoCo Bond hybrid asset class straddling both the Equity & Fixed Income space.  Designed off the back of the last global financial crisis, investment banks were forced to issue these as part of their ‘Masters of the Universe’ bonus package, rather than hand over the cash and these new instruments became known as Contingent Convertible Bonds.

These instruments are novel as they are designed in such a way that as the Common Equity Tier 1 (CET1) ratio falls below the designated trigger level, the CoCo Bonds are either converted to common equity as a means to boost the issuer’s level of CET1 or are written down to similarly boost the firm’s capital levels.

The sell-off in March saw the banking sector, along with the energy sector, hit the hardest.  The good news is that, assuming the banks survive, in the same way that as a fund’s NAV gets lower the effective dividend yield increases, so it is with CoCo Bond ETFs as the bank’s balance sheet deteriorates.  If we still believe in the adage of ‘Too Big To Fail’ then this ETF offers a good source of income.

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