Income options for your 2024 ISA

With central banks having increased interest rates progressively over the last two years in response to higher inflation, the headline returns on cash have been rising. Savers have been enjoying the highest cash rates in a generation, which has arguably made decisions on whether to hold cash or invest in riskier assets for the prospect of a higher long-term return, a little more nuanced.

Now, with the battle against inflation seemingly won, at least for the time being, most economists expect UK and US interest rates to decline this year and next. What will this mean for income investors and where could they consider looking for an alternative to cash as interest rates come down?

The theory behind monetary policy

In the modern economy, central banks (such as the US Federal Reserve, the Bank of England and the European Central Bank) use interest rates as a primary tool for controlling the tempo of economic activity. Known as monetary policy, this technique has gained in prominence since the 1980s, taking over from fiscal policy (which uses the levers of tax and government spending to manage the economy) as the key weapon in controlling inflation and maintaining a steady rate of economic growth.

When inflation increases, this is seen as a sign that an economy is running too fast or close to its maximum capacity. Central banks respond by increasing interest rates to cool economic activity. This also encourages consumers, businesses and investors to be more risk averse – collectively, they are likely to spend and borrow less, and become more attracted to the rising rate of return available on defensive assets such as cash and bonds.

By contrast, when inflation moderates, or if an economy looks like it may be slipping into recession, central banks reduce interest rates to encourage more economic activity, stimulate more borrowing and encourage more risk taking. Inevitably, this reduces the attractiveness of cash and bonds, and encourages investors towards riskier assets such as equities and real estate.

Where are we now?

In 2022, inflation rose significantly and central banks increased interest rates in response. As a result, economic growth rates generally moderated, but most major economies have avoided recession. Inflation rates have reduced from more than 10% to 4.0% in the UK and to 3.1% in the US, at the time of writing. The most recent data has been quite mixed, so it is too early to decisively declare victory over inflation, but most economists now expect the next move in interest rates from the world’s major central banks to be down.

According to the theory, we appear to be moving into an environment which should be more supportive for riskier assets. Indeed, testing the theory in reality, historic data does suggest that stocks do tend to outperform bonds and cash when the Fed starts to cut interest rates, as we explored here, although clearly this is not guaranteed.

Source: CFA Institute SBBI database, Schroders, Federal Reserve Economic Data (FRED). For the full dataset and further details on the methodology, please click here. Past performance is not necessarily a guide to the future and may not be repeated.

Equities are a credible source of income

As cash rates diminish, there are other interesting options for income investors to consider. For example, equity markets offer the prospect of an attractive starting yield and the potential for long-term growth. With equities, investors must be willing to tolerate short-term volatility in the value of their investments and accept the risk that they may not get back the full value of their original investment.

Nevertheless, the long history of financial markets suggests that investors have ultimately been well-rewarded for embracing the additional risk involved with equity markets, particularly if they take a long-term view of say three-to-five years or preferably more. In large part, this is because equity income stems from company dividends. Businesses operate in the real economy, which means their revenues, profits and cashflows can rise over time in response to inflation. In turn, this means that dividends also tend to rise over time, hence the opportunity for capital growth, as well as an income that is potentially resistant to inflation.

In the current environment, some regional equity markets offer a very attractive starting yield, and investors don’t need to look much further than the domestic market for exciting income opportunities.

The UK’s FTSE All Share Index currently yields 3.8%1, making it one of the highest yielding equity markets in the world. Meanwhile, active investors have the opportunity to build a portfolio with an even more enticing starting yield. The Schroder Income Growth Fund (SCF) looks across the entire UK market cap spectrum for the best opportunities, blending dividends from different parts of the market with the aim of achieving income growth in excess of inflation and capital growth as a result of that rising income. Indeed, it has raised its dividend every year since its launch in 1995, and its rate of growth has outpaced inflation. The trust currently yields 4.6% and the investment team aims to deliver dividend growth that outpaces inflation over the medium term, but this is not guaranteed. The trust is classed as a ‘Dividend Hero’ by the Association of Investment Companies (AIC), an accolade awarded to the few investment companies that have consistently increased their dividends for 20 or more years in a row.2

Further afield, Asia also looks interesting from the perspective of equity income. Asian equity investing has always been a core strength for Schroders, with bottom-up stock picking at the heart of its historic success. The region is home to an increasing number of world-leading companies, and supportive demographics and relatively low debt burdens should represent helpful economic tailwinds in the years ahead. Meanwhile, its management teams have generally been becoming much more disciplined in their approach towards shareholder returns. The Schroder Oriental Income Fund (SOI) was launched in 2005 to capture these trends. It is managed by Richard Sennitt who is supported by a wealth of resources, both locally in London and on-the-ground in Asia. With a current yield of 4.5%,3 this trust has delivered dividend growth each year since its inception and is recognised as a ‘Next Generation Dividend Hero’ by the AIC.4

Real estate for real returns

Another asset class that has a good track record of delivering income and growth is real estate. As the name suggests, like equities, real estate is a “real” asset, which means investors should be protected against the erosive power of inflation over time.

As is the case in equity markets, the yield available on real estate assets currently looks enticing for income investors. Annual yields of more than 6% are currently available on UK real estate investment trusts, such as those run by Schroders. Long-term total returns have also historically been attractive, underpinned by a high income that can rise steadily over time.

Meanwhile, real estate investment trusts are currently trading at steep discounts. This reflects economic uncertainty and widespread disinterest in the asset class at present. If interest rates are heading lower, however, now could be an interesting time to take a look at the sector.

The Schroder Real Estate Investment Trust (SREI) invests in UK commercial property and seeks to harness the 'green premium' with the aim of delivering consistent income and capital growth. Its first-of-its-kind brown-to-green investment strategy aims to meet the growing demand for more sustainable buildings by transforming the environmental performance of the portfolio’s assets over time. This should allow investors to capture the rental and valuation premium that buildings with genuine green credentials can command, underpinning the portfolio’s valuation and opportunities for growth. It currently offers a yield of 8.1% which is well ahead of current cash rates and is available at a 26% discount to its net asset value (NAV).5

Meanwhile, the Schroder European Real Estate Investment Trust (SERE) focuses on ‘winning cities’ across Continental Europe, such as Berlin, Hamburg, Stuttgart and Paris. These offer higher levels of growth, exposure to higher-value diversified industries and well-developed and improving infrastructure. In short, winning cities represent places where people want to live and work, which should correspond to a compelling long-term investment strategy. Its high-quality diversified property portfolio looks capable of delivering a reliable income stream alongside potential for long-term growth through active asset management. All of the portfolio’s rental income is subject to indexation (80% annual), which should provide good levels of inflation protection for investors. The shares currently yield 6.5% and trade at a 36% discount to NAV.6

Conclusion

Cash investors have been enjoying the best rates in years, but these may not last much longer. It should be remembered that every cycle has its own unique characteristics, but history suggests that equities and other risk assets tend to perform well when central banks reduce interest rates.

There are compelling alternatives to cash in the current investment environment for investors willing to take a bit more risk in asset classes such as equities and real estate. In the very long run, that risk has historically been well rewarded, with rising incomes and real capital growth. Schroders has a range of investment trusts offering an attractive starting income and the potential for inflation-beating growth over time.

References

[1] Source: London Stock Exchange as at 19 February 2024

[2] Source: The Association of Investment Companies as at 27 February 2024

[3] Source: Schroders as at 31 January 2024

[4] Source: The Association of Investment Companies as at 27 February 2024

[5] Source: Schroders, yield as at 30 September 2023, discount as at 19 February 2024

[6] Source: Schroders, yield as at 30 June 2023, discount as at 19 February 2024

For help in understanding any terms used, please visit address https://www.schroders.com/en/insights/invest-iq/investiq/education-hub/glossary/

We recommend you seek financial advice from an Independent Adviser before making an investment decision. If you don't already have an Adviser, you can find one at www.unbiased.co.uk or www.vouchedfor.co.uk. Before investing in an Investment Trust, refer to the prospectus, the latest Key Information Document (KID) and Key Features Document (KFD) at www.schroders.co.uk/investor or on request.

Fund Risk Considerations

Schroder Income Growth Fund plc

• Concentration risk: The company may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the company, both up or down, which may adversely impact the performance of the company.
• Distribution risk: As a result of fees being charged to capital, the distributable income of the company may be higher but there is the potential that performance or capital value may be eroded.
• Concentration risk: The fund may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up or down.
• Currency risk: The fund may lose value as a result of movements in foreign exchange rates, otherwise known as currency rates.
• Derivatives risk: Derivatives, which are financial instruments deriving their value from an underlying asset, may be used to manage the portfolio efficiently. The fund may also materially invest in derivatives including using short selling and leverage techniques with the aim of making a return. A derivative may not perform as expected, may create losses greater than the cost of the derivative and may result in losses to the fund.
• Gearing risk: The company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that investment could be lost, which would result in losses to the fund.
• Liquidity risk: In difficult market conditions, the fund may not be able to sell a security for full value or at all. This could affect performance and could cause the fund to defer or suspend redemptions of its shares, meaning investors may not be able to have immediate access to their holdings.
• Operational risk: Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the fund.
• Performance risk: Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.
• Counterparty risk: The fund may have contractual agreements with counterparties. If a counterparty is unable to fulfil their obligations, the sum that they owe to the fund may be lost in part or in whole.
• Market risk: The value of investments can go up and down and an investor may not get back the amount initially invested.

Schroder Oriental Income Fund Limited

• Concentration risk: The company may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the company, both up or down, which may adversely impact the performance of the company.
• Counterparty risk: Investments such as warrants, participation certificates, guaranteed bonds, etc. will expose the company to the risk of the issuer of these instruments defaulting on paying the capital back to the company.
• Currency risk: The company can be exposed to different currencies. Changes in foreign exchange rates could create losses.
• Emerging markets risk: Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty and operational risk.
• Currency risk: The fund may lose value as a result of movements in foreign exchange rates, otherwise known as currency rates.
• Emerging markets & frontier risk: Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty, operational and liquidity risk than developed markets.
• Gearing risk: The company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that investment could be lost, which would result in losses to the fund.
• Liquidity risk: In difficult market conditions, the fund may not be able to sell a security for full value or at all. This could affect performance and could cause the fund to defer or suspend redemptions of its shares, meaning investors may not be able to have immediate access to their holdings.
• Operational risk: Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the fund.
• Performance risk: Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.
• Currency risk (including Onshore renminbi): The fund can be exposed to different currencies. Changes in foreign exchange rates could create losses. Currency control decisions made by the Chinese government could affect the value of the fund's investments and could cause the fund to defer or suspend redemptions of its shares.
• Derivatives risk: Derivatives, which are financial instruments deriving their value from an underlying asset, may be used to manage the portfolio efficiently. A derivative may not perform as expected, may create losses greater than the cost of the derivative and may result in losses to the fund.
• Stock Connect risk: The fund may be investing in China "A" shares via the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect which may involve clearing and settlement, regulatory, operational and counterparty risks.
• Counterparty risk: The fund may have contractual agreements with counterparties. If a counterparty is unable to fulfil their obligations, the sum that they owe to the fund may be lost in part or in whole.
• Market risk: The value of investments can go up and down and an investor may not get back the amount initially invested.

Schroder Real Estate Investment Trust & Schroder European Real Estate Investment Trust

• Credit risk: A decline in the financial health of an issuer could cause the value of its bonds, loans or other debt instruments to fall or become worthless.
• Currency risk: The fund may lose value as a result of movements in foreign exchange rates.
• Interest rate risk: The fund may lose value as a direct result of interest rate changes.
• Liquidity risk: The fund is investing in illiquid instruments. Illiquidity increases the risks that the fund will be unable to sell its holdings in a timely manner in order to meet his financial obligations at a given point in time. It may also mean that there could be delays in investing committed capital into the asset class.
• Market risk: The value of investments can go up and down and an investor may not get back the amount initially invested.
• Operational risk: Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the fund.
• Performance Risk: Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.
• Property development risk: The Fund may invest in property development which may be subject to risks including, risks relating to planning and other regulatory approvals, the cost and timely completion of construction, general market and letting risk, and the availability of both construction and permanent financing on favourable terms.
• Real estate and property risk: Real estate investments are subject to a variety of risk conditions such as economic conditions, changes in laws (e.g. environmental and zoning) and other influences on the market.
• Concentration risk: The company may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the company, both up or down, which may adversely impact the performance of the company.
• Gearing risk: The company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that investment could be lost, which would result in losses to the fund.

Important information

This communication is marketing material. The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

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Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.

Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.

The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.

Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.