21st October, 2022
Blog, IC Insights
The Re-Emergence of Income
There is a fair amount of frenzied media commentary around Global and UK Inflation at present. We therefore thought it was sensible to try to provide some perspective around the effects of inflation on our Portfolios, and the squeeze on income, neither of which in the short term are pleasant.
Let’s start with a question… which one of the following situations is preferable?
- A Portfolio with a capital valuation of £500,000 and a forward income stream over the next 10 years of £90,000.
- A Portfolio with a capital value of £435,000 and a forward income stream over ten years of £239,250.
Now before you answer, let’s look at a buy to let property example to explain how these two situations may have come about.
A house is purchased for £100,000. The tenant pays a rent of £5000 per annum, equivalent to 5% of the value. If the house value were to increase to £200,000 over ten years, but the rent remained the same at £5000 per annum, the yield or income would now be 2.5% per annum, not 5%. Conversely, if the house price were to drop to £50,000 and the rent remained the same, the yield or income would then be 10% per annum.
The above scenario is a good example of when assets rise in value, the actual percentage return you get relative to the value of the asset decreases. And as asset prices rise, the owner of the asset will consider whether or not to capitalise on the increased valuation. As we know, something is only worth what someone else is prepared to pay, and from an investment perspective, the house was a much better investment when it had a 5% yield, compared to 2.5%.
Attractiveness is also a relative term when it comes to investing. When interest rates are zero, even a yield of 2.5% could still be seen as reasonable. But consider what happens when interest rates are 4% or 5%? Naturally the demand for the 2.5% income return will not be strong and the capital value will have to fall until it reaches a level where the yield is attractive again.
The market environment since the financial crisis of 2007-08 had been a very strong one, but with 0% interest rates, the level of income and dividends produced from assets reduced to the point where investment portfolios were almost entirely reliant on capital growth. Another easy example is to think about why holding cash hasn’t been attractive – it has paid next to nothing for decades, pushing clients to take more risk to obtain any form of return.
That brings us to the good news of today. In December the income yield on our Low Risk Portfolio was 0.9% per annum. As inflation expectations have forced interest rates up, assets have had to reprice and capital values have moved lower. Given our ability as discretionary fund managers to sell and buy things very quickly, we have been able to take advantage of many opportunities to add quality assets at discounted values.
In the property example the capital value had to fall 50% for the income return to double. Our Low-risk portfolio has fallen by around 13% though the level of forward income from here is now above 5.5% per annum. Hence the reason for the earlier question…
So despite the difficult markets, you can hopefully see that the changes we have made to the portfolios this year will provide an excellent forward income stream, which in itself is a great foundation for future returns once markets have settled. Our new income stream will come into our portfolios whether we like it or not, and we like it! Whether capital values rise will very much depend on the trajectory of inflation. At present it is high, though is coming from a very low base of close to 2% for the last decade. Although we don’t expect 2% anytime soon, as we progress over the months ahead, we do expect to see some significant falls across 2023.
Whilst it is painful at the moment, investment markets are resetting and building the foundations for the next decade of returns. We have repositioned our portfolios this year to take advantage of a new healthy income contribution which is now built into our portfolios for the years ahead, providing more security in volatile times, and better growth prospects for when markets settle down.