How investors can update their income strategies

February 15, 2022 10:28
Some healthcare royalties funds help to finance the costs of research and development for new drugs in return for payments linked to a drug’s sales.  Photo: Reuters

It has been more than a decade since the 2008 financial crisis, yet the main challenge for investors hasn’t changed: finding reliable income to compensate for feeble bond yields without taking undue risk.

Largescale government support to safeguard the financial system after the collapse of Lehman Brothers trapped western policymakers in a prolonged cycle of low interest rates and high debt. To pile on the pain, recent measures to cushion the economic impact of Covid-19 has extended this cycle.

Suppressed (and in many cases negative) investment-grade bond yields have driven investors into riskier asset classes in search of growth and income, most commonly high-yield bonds and equities.

Equity investing in particular has become predominant – driving up valuations and eating into portfolio diversification. This global trend shows few signs of slowing in the face of rising inflationary pressures, even when the tapering of government asset purchases is exposing the lack of value in consensus trades.

The need to find dependable income has never been greater – especially in Asia, where income investing is ingrained due to inadequate pension provision for the region’s rapidly ageing population.

The ways to source income have evolved – from bond coupons, dividend payments and renting out property to creating content on Youtube and e-books, peer-to-peer lending and staking cryptocurrencies.
Still, it’s the traditional methods involving bonds, stocks and property that still prevail in Asia. Notably, neither Hong Kong nor Singapore tax dividend income nor impose capital gains tax on securities.

However, dividend-paying companies typically sit in the value category, meaning investors particularly in Asia may have missed out on the sharp rally in growth stocks over recent years, including US tech firms.

In addition, many dividend strategies use covered call options to enhance income. The writer of a covered call receives income in exchange for taking on the bet that a stock will not move beyond a set level. However, if the stock rises above that, the holder of the call option gets the upside, not the writer.

Thankfully, the most innovative fund managers have come up with smarter ways to meet investors’ income needs without limiting portfolio diversification or capping upside potential.

Some use dividend capture strategies. These screen the global equity universe to find companies that issue regular dividends (annual or semi-annual) and those set to issue special dividends, which are one-off payments to shareholders on the back of a cash windfall, such as the sale of an asset. Rotating in and out of these dividend events tactically throughout the year can seriously enhance portfolio yield.

Dividend capture strategies seek to maximise income, while not missing out on market growth. During bouts of volatility, investors can still receive income as they wait for markets to recover.

Separately there are strategies that invest in a range of listed alternative assets with reduced correlation to traditional equity markets such as infrastructure, specialist credit, private equity and other previously illiquid assets now tradeable on exchange.

These assets tend to have different revenue drivers to traditional equities and bonds, enabling them to provide regular income irrespective of broader market conditions. This has opened up a new universe of opportunities for non-professional investors to build genuinely diversified income portfolios.

Infrastructure assets, for example, have a track record of delivering stable, long-term returns. Areas such as solar and wind farms offer promise given growing demand for renewable energy and the prevalence of government subsidies.

We would also highlight niche areas such as listed healthcare royalties funds that help to finance the costs of research and development for new drugs. In return for up-front funding, these funds receive payments – or royalties – linked to a drug’s sales. This alternative form of financing offers high income potential in line with a product’s clinical development.

The payments are often tied to the life of a patent – making the risks idiosyncratic to each drug and largely independent of global economic cycles. In light of the Covid-19 pandemic, we would expect healthcare spending to continue – pointing to the likely durability of this revenue stream.

Of course, identifying which assets provide good, long-term return potential at acceptable levels of risk takes experience, good judgment and extensive resources. So investors need to choose the right investment partner.

Ultimately, the need for income may not have changed since the 2008 financial crisis but income investing has evolved as solutions providers have gotten smarter. Now it’s up to investors to update their strategies.

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Head of Wholesale, Asia Pacific, abrdn

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