Become a convert to the income cause

While the majority of clients and advisers may have little time for dealing with the intricacies of stock-specific research the dividend cut announced by FTSE 100 Centrica earlier this month (19 February) is unlikely to have passed by unnoticed.

The company's new chief executive, Iain Conn, who only took the reins from Sam Laidlaw in January, sanctioned a 30% cut in the final payment and 21% reduction in the full-year figure. Such swingeing reductions are relatively rare for a member of Britain's corporate elite but they act as a reminder of three things:

• First, the influence oil and gas, and commodity prices in general, continue to exert upon the UK equity market. Between them, oils and miners are expected to generate around a third of the FTSE 100's aggregate pre-tax profits and just under 30% of its dividends in 2015, according to consensus forecasts.
• Second, there are few worse investments than an income stock where the dividend is cut. Centrica compounded income-seekers' woes and the payout reduction with a share price fall of some 8% on the day.
• Third, the hunt for reliable and sustainable income remains as testing as ever. If clients do want stock-specific exposure then it is important to check out key metrics such as earnings and free cashflow cover of the dividend. It is also important to use not just market forecast numbers but stress-tested ones, which take account of any unexpected downturn in profits and the company's average profits over a cycle.

FTSE 100 firm Centrica has announced a dividend cut for 2014

Source: Company Accounts

The timing was interesting as Centrica's full-year figures came out just after the publication of Henderson Global Investors' latest analysis of the prospects for global equity income in 2015. The fund management giant concludes global dividend payments will rise by just 0.8% this year, well below the trend growth rate seen since 2009 when the latest equity bull run began.

Henderson Global Investors’ research suggests global dividend payments could be flat in 2015

Source: Henderson Global Investors

Besides lower special dividends from behemoths such as Vodafone, Henderson cites lower global growth expectations, falling oil prices and the strong dollar as reasons for its caution, a view Centrica's misfortunes are unlikely to change.

This does not mean equity income funds should be spurned. On the contrary, this is where good fund managers can make a difference, picking out those firms where dividends are safe or can be hiked and avoiding those where the payment could be cut or even passed.

Equally, the Centrica experience may prompt some clients to wonder whether there is an alternative. Under these circumstances the often neglected area of convertible bonds, and funds dedicated to them, may be worthy of investigation. The tables below compare and contrast the best performers in the Global Equity Income and Global Convertible categories. The annualised total returns on a five-year view are lower, and the current yields lower, from the convertible collectives but any clients nervous about a bond or equity market wobble (or both) may be intrigued by the potential of these hybrid instruments.

For the record, there is also an Exchange-Traded Fund on the asset class. The SPDR-provided instrument tracks the Thomson Reuters Qualified Global Convertible index only began trading in October 2014 but it already has some £125 million in assets under management. It comes with the ticker of GCVB and the ISIN code of IE00BNH72088.

Clients can also examine the merits of a dedicated investment trust, JP Morgan Global Convertibles Income, listed on the London Stock Exchange since June 2013. Its £221 million market cap puts leaves it on a 1.8% premium to net asset value at the time of writing and after a minor sell-off in the second half of 2014 the investment company comes with a 4.4% dividend yield. It trades under the ticker JGCI and the ISIN code GG00B96SW597.

Best performing Global Equity Income funds

Source: Morningstar, for the Global Equity Income category Where more than one class of fund features only the best performer is listed.

Best performing Global Convertible Bond funds

Source: Morningstar, for Global Convertible Bond and Global Convertible Bond (GBP hedged) categories
Where more than one class of fund features only the best performer is listed.

Six of one

A convertible bond is, as its name suggests, a fixed-income instrument which offers a (usually pre-determined) coupon. This coupon will tend to be lower than that on offer from a straight bond but from clients' perspective convertibles offers two potential advantages in return

• Potential extra value relative to a vanilla bond, in the form of a hidden call option and the chance to convert the bond into equity, at what could be an advantageous price.
• More downside protection than owners of the straight equity would get, in that the bond will provide a floor to the valuation, assuming the credit proves sound and the issuer does not go broke.

In sum, the convertible bond holder will benefit from the upside if the company's share price rises sharply but be sheltered from the worse of the fall should the equity's valuation take a pounding. Barring a credit event and default, the convertible holder can get 100% participation in the share price upside but find the bond recovery price offers a downside floor.

Davide Basile, lead manager of the RWC Global Convertible Bond fund since 2010 neatly summarises the concept for this column by describing it as an “asymmetric returns profile,” where the value of the option provides equity-style upside and the downside is protected by the bond element and income.

In the diagram below the solid black line represents how a straight bond's return profile would look and the dotted one how a share price might rise. The red line then shows how the convertible would perform under this set of circumstances and it is the curvature of this line that Basile’s fund seeks to exploit.

How convertibles offer an asymmetric return profile

Source: RWC

The term for the relationship between the convertible and the equity is known as 'delta' and it measures the degree to which the convertible owner shares in the equity upside. At the bottom of the red line, delta is zero and at the top it is 100%.

Basile tries to play in the sweet spot around 50%, to maximise potential capital gains and get in near where the rate of change in the delta – known as 'gamma' – is greatest while still keeping downside protection from the bond element of the convertible.

The RWC fund will not own an instrument all the way up to where the delta is 100% and is unlikely to convert either. The net result is a portfolio designed to try and capture roughly two-thirds of the equity upside and potentially suffer around one-third of the downside.

After a 30-year bull run in fixed income and six-year winning streak in stocks, some clients might like to investigate this risk-reward ratio, especially as they will be able to bank some income at the same time.

Half a dozen of the other

For the downside protection to work any convertible fund manager must therefore focus on credit research first. If this proves inadequate and the issuer goes bust then there is no downside protection at all, barring credit recovery value. The emphasis is thus upon risk-adjusted returns, in Basile's case gauging the premium to the bond floor relative to the potential for losses if the equity deteriorates significantly.

One other potential benefit of a convertible bond is its low duration (see Income-seekers must face the duration test 13 February here). Remember that

• Macaulay duration measures the average weighted time to maturity of all coupon and principal payments
• Modified duration quantifies interest rate risk and how much a bond or portfolio of bonds will move in price relative to a 1% shift in borrowing costs.

At a time when the UK 10-year gilt yield has risen from a low of 1.36% (30 January 2015) to 1.83% and the 10-year US Treasury from 1.67% (2 February) to 2.2%, this may provide some further welcome downside protection. Basile's fund comes with an average duration of just 1.8 years so it would benefit from any fresh decline in bond yields (and advance in bond prices) but should not suffer as much if benchmark Government paper yields march higher.

Convertibles' low duration may appeal to clients worried about interest rate rises and surges in Government bond yields

Source: Thomson Reuters Datastream

Convertibles may not appeal to all clients. Some will prefer the juicier yields and higher potential capital gains offered by equities, albeit in exchange for the increased risk of capital loss. Others may prefer what they see as the greater security provided by fixed-income, or at least seek some protection from rising rates through a flexible or short-duration bond fund.

Yet advisers may view them as suitable for some clients, depending upon their overall investment strategy, time horizon, target returns and appetite for risk. This middle path between fixed income and equity may consider have a role to play in balanced portfolios, especially if any clients are concerned about the prospect of a market setback or even increased volatility.

Russ Mould, Investment Director, AJ Bell.