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Building resilience for income investors

 

November 2021

Nalaka De Silva and Jennifer Mernagh, Investment Managers,
Aberdeen Diversified Income and Growth Trust plc

  • Income investors need to prioritise two elements in the years ahead: inflation and diversification
  • Investors need to bring in alternative sources of return to balance equity exposure and provide stability in portfolios
  • Private markets should be a stable source of income and capital growth in the years to come

In most cases, equity markets have matched or exceeded their pre-pandemic highs. However, the ride has been uncomfortable, particularly for income-seekers. Income was already tough to find, but the pandemic made it worse with volatile dividends and sliding yields from fixed income. Can income investors ‘build back better’ as the dust settles?

To our mind, income investors need to prioritise two elements in the years ahead: inflation and diversification. Inflation has been a preoccupation for markets in recent months – and rightly so. Consumer price inflation is running at 5.3% in the US and 3.2% in the UK1.While abrdn forecast is that these higher levels of inflation are transitory, inflation may reset at a higher level than has been normal over the past few years and even a moderate inflation environment can put a dent in investors’ long-term plans.

Diversification is crucial at a time when low interest rates are constraining the returns available from fixed income. Investors need to bring in alternative sources of return to balance equity exposure and provide stability in portfolios. Equally, the low interest rate environment has favoured some alternative asset classes – we would highlight areas such as royalties and litigation finance where high yield and long duration cash flows combine.

Opportunities and risks

At the moment, we see opportunities and risks across all the financial markets in which we invest. In equities, for example, earnings momentum is strong as economies emerge from the pandemic. Economists and analysts significantly misjudged the ability of businesses, people and economies to adjust to a different environment. However, valuations are stretched in some areas and there are still risks that the virus may evade the vaccines and disrupt markets once again.

The fundamentals in credit markets are better than they were last year and investors still receive a pick-up from high yield bonds. However, the spread offered by investment grade bonds is very thin. The pandemic saw considerable re-leveraging and while default risk is low, the risk/reward payoff in this part of the credit market is weak. In private markets, the dispersion of returns continues to be very wide. It has never been more important to target high quality deals with good management teams across private equity, venture capital and development areas.

Refreshing the asset allocation

As we have rebuilt the Aberdeen Diversified Income and Growth Trust, we have tried to keep these factors in mind. We have sought to ensure a spread of returns and to rebalance away from a focus on public markets to ensure diversification and consistency. Having completed the restructuring, the portfolio has 10% in equities, having moved away from passive and into environmental, social and governance (ESG) tilted global strategies and green infrastructure, plus UK mid-cap exposure. We have 25% in fixed income and credit, focusing on asset-backed lending, emerging market debt and global loans. We have 25% in listed alternatives, which is particularly important for diversification in areas such as speciality finance. Finally, we have 45-55% in private markets, centring it on private credit and infrastructure.

The shift to private markets has been particularly important. We believe that they will potentially be a stable source of income and capital growth in the years to come. Private markets are a broad church. They include venture capital, private equity and private credit, but also real estate and infrastructure. Many of the opportunities we are including in the portfolio are focused on contracted, inflation-linked cash flows. This helps improve the predictability of income for our investors. As part of the same drive, we have moved away from more volatile parts of the equity and fixed income markets.

Our process in action

We would highlight two holdings as an illustration of our process in action. The European Residential Opportunities Fund, for example, is looking for opportunities in commercial real estate in the post-Covid environment. Its managers are seeking opportunities to convert unused office space into residential property. It sees a valuation and rental uplift from rezoning and refurbishing these assets. The residential outlook is strong across Europe. The group is also ensuring that buildings conform to ‘green’ standards from regulators and residents.

Healthcare Royalty Partners 4 sits in our alternatives segment. The pandemic has highlighted the importance and potential for areas of the biotech market. This company takes pharmaceutical intellectual property and puts it in a structure that allows us to invest through various phases. The healthcare sector has significant tailwinds over the next few years, in terms of demographics and government spending. The group is also acutely aware of the associated ESG issues in healthcare, such as access and affordability, product quality and distribution.

We believe that the portfolio is now in a good position to deliver its target of long-term capital growth and a 6% income target. Importantly, we believe that yield will potentially be stable, diversified and income protected. Our focus on ESG helps ensure long-term resilience. These factors are likely to be vitally important for investors as we emerge from the pandemic.

Important information

Risk factors you should consider prior to investing:

  • The value of investments and the income from them can fall and investors may get back less than the amount invested. The investment places capital at risk and there is no guarantee that the performance target will be achieved over any time period.
  • Past performance is not a guide to future results.
  • Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
  • The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
  • The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
  • There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
  • As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid offer spread. If trading volumes fall, the bid-offer spread can widen.
  • Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends. Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
  • The Company may invest in alternative investments (including direct lending, commercial property, renewable energy and mortgage strategies). Such investments may be relatively illiquid and it may be difficult for the Company to realise these investments over a short time period, which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
  • Investing globally can bring additional returns and diversify risk. However, currency exchange rate fluctuations may have a positive or negative impact on the value of investments.

Other important information:

Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer, investment recommendation or solicitation to deal in investments.

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1 https://www.bloomberg.com/news/articles/2021-09-14/consumer-prices-in-u-s-increase-by-less-than-forecast
https://www.cnbc.com/2021/09/15/uk-inflation-rockets-to-3point2percent-in-biggest-leap-on-record.html

Risk Warning
Risk warning
The value of investments and the income from them can go down as well as up and you may get back less than the amount invested. Please refer to the relevant Key Information Document (KID) prior to making an investment decision. Please be aware of scams that can affect investors.