Adventurous Investor

June 25, 2010 6:10 pm

The scramble for yield

June hasn’t been kind to income investors

June hasn’t been kind to income investors. BP’s trials and tribulations have thrown a substantial spanner in the works of investment strategies based on reinvesting dividends.

So where can you turn to for alternative sources of income? In the listed funds sector, the growing demand for innovative sources of income has resulted in a rash of new fund launches. Neuberger Berman’s Distressed Debt Investment fund, for example, is now offering investors access to senior, asset-backed loans in the US distressed debt market – where bonds issued by companies in financial difficulty are sold at discounted prices. It is a fixed-life fund that offers a combination of small income payments, based on underlying loan interest payments, plus regular capital returns. It hopes these will add up to around 20 per cent a year.

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Adventurous Investor

Gravis Capital Partners, meanwhile, is launching its Infrastructure Investment closed-end fund This will target an income payment of about 8 per cent a year from a portfolio of PFI bond assets.

And Aberdeen is launching a Latin American Income Fund that offers a regionally specific mix of dividend-paying equities plus local currency government debt. It aims for a blended payout of about 4.25 per cent a year.

But while these existing and putative closed-end funds are clearly focused on very different ideas, they can all be measured against the same yardsticks.

First, execution risk: is the manager really a specialist at the task in hand? Neuberger is a very big player in the US distressed debt market, while Aberdeen has a strong reputation in emerging market debt and income-based equities in the emerging world. Gravis, however, is relatively new to the game – although it has been running a non-listed version of its fund for a few years now.

Second, macro risk: how vulnerable is their income to sudden changes in the economy or government policy? I have mild reservations about all three funds. Neuberger is exposed if we are about to enter a double dip recession – US corporate distressed debt could drop sharply again.

Aberdeen will know that political risk in Mexico is still high and a sudden drop in oil prices could wreak havoc in Brazil. Gravis is reliant on government PFI deals and, while I have no doubt that PFI projects will continue under a Tory/Liberal government, the worry is that nearly all capex will be savaged regardless of its ownership structure – prompting a drying up of deal flow.

Third, market timing risk: is the income-producing asset class being targeted at investors at the top of the valuation cycle? Again, I have my worries with all three funds. I suspect that Neuberger’s deal flow is second to none but absolutely everyone has been telling me that distressed debt/junk bond debt is “the place to be” for at least 9 months – which makes me nervous. Ditto Aberdeen’s emerging market debt – spreads over supposedly risk-free developed world debt have markedly narrowed while local equity markets are not exactly cheap.

Fourth, opportunity cost risk: are there better alternatives in these asset class sectors? I’d suggest all three funds pass this test. In distressed debt, there are no real competitors in the UK market at all, so Neuberger is bringing a new idea to UK investors. In Aberdeen’s emerging markets space, there are
(a) hardly any listed emerging markets debt funds and (b) even fewer value-orientated, income plays in emerging markets equities, and certainly none that do both. And compared with Gravis’ target yield of 8 per cent, most listed infrastructure funds are yielding closer to 5 per cent.

But if you think these risks are too great, don’t give up on boring old blue chip FTSE 100 stocks, sans BP’s dividends.

A simple stock screen of the UK market reveals a heap of quality stocks with robust earnings growth that continue to pay out a decent dividend yield.

Maybe now is the time to buy a conservatively managed equity income fund, instead!

adventurous@ft.com

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