AJ Bell Income and Growth fund update – plugging the (income) gap

To all investors seeking an income, the hit from COVID-19 has come quick and hard. Old rules of thumb have been upended. Governments and central banks have stepped in in ways even those with the battle scars of 2008/09 would have thought unthinkable. As the virus has spread, workforces have been forced into hibernation, causing dividend payments from shares to quarantine themselves along the way.

The dividend cuts from this crisis are stark. Many are precautionary in nature, and lots have been Government- or regulator-mandated. Now, faced with a groundswell of public opinion, even organisations which are willing and able to make distributions are opting to husband their cash for a later date.

For portfolios with income targets or objectives, this places investors in something of a quandary. Do you sit tight and accept lower income for the immediate future? Do you tip-toe past the dividend landmines to look for income in other stocks or sectors? Or do you abandon shares altogether and seek out more certain sources of income?

This is the decision facing us in the AJ Bell Income & Growth fund, which has income objectives etched into its DNA.

We’re pivoting to global high yield bonds

Thankfully, as managers of multi-asset portfolios, the range of options available to us is larger than for managers of single-strategy funds. So rather than shrug our shoulders and accept lower yields, or spin the wheel on who will chop their dividend next, we have opted to take a third path. We want to pivot away from UK equities into global high-yield bonds – and shift 10% of our UK share exposure in the process.

But wait, aren’t bond default rates likely to go up?

Yes. Default rates for bonds will increase. And yes, some bonds in the high-yield world won’t make it to the other side. We have factored this into our decision-making process, where yields on global high yield in excess of 10% already account for significant increases in defaults. Even after taking higher defaults into account, we would expect the annualised return on high yield from here to be more like 8.5–9.0% per year – a figure in line with our long-term expectations for equity markets.

Why not go for safer forms of income, like government bonds or even investment-grade debt?

These were options we considered. Alongside our income objectives, the goal of the fund is to not only produce an income of 3–5% each year, but also to protect against the impact of inflation. Given the degree of central bank intervention in more traditional bond markets, this inflation protection is simply not available in ‘higher-quality’ bond instruments.

But what about when the recovery eventually does come? Won’t you miss out on the rally?

We don’t think so. The overall performance of high-yield bonds and shares tends to be very similar over time. The sources of return differ, but the overall return is closely linked. In the event of market conditions that see equity markets turning skyward, we would expect the same conditions to advance high-yield bonds at the same time.

Aren’t high-yield bonds massively exposed to the oil sector, though? What about the oil price? Surely that hurts high-yield bonds more than shares?

Yes, there is some oil market exposure in the high-yield bond markets – but nothing like as much as commonly perceived. The sector breakdown of the Global High Yield index and the FTSE 100 index demonstrates where the biggest oil and gas exposure sits:

Source: Bloomberg LP, April 2020

So how have you implemented this within the fund?

The Income & Growth fund will mirror the approach we’ve already taken with the Income fund: initiating a position in Baillie Gifford High Yield Bond Fund to enact the high-yield position.

To fund the switch, we will be making equal reductions in our iShares FTSE 100 tracker and the Man GLG Income Fund.