Investing for income in a world of inflation

Once upon a time, there was a real return on cash. For much of modern economic history, official interest rates would consistently be above the prevailing rate of inflation. That all changed in the global financial crisis of 2007-09, as the chart below illustrates, with global central banks slashing rates to close to zero and then keeping them there for more than a decade. Although UK interest rates have climbed in recent months back towards what used to be considered normal levels, they remain significantly below the current rate of UK inflation.

This means that UK deposit holders are seeing the value of their cash savings gradually eroded by the effects of inflation. Indeed, although interest rates are now higher, the rate of erosion has increased as inflation has risen over the last couple of years. There may now be a ‘nominal’ (before inflation) return on cash, but the ‘real’ (after inflation) return is quite significantly negative. Cash savers beware – things are not looking quite as rosy as they may appear at first glance.

Source: Koyfin to 02/02/2023
Past performance is not a reliable indicator of future results

So, what are the alternatives to cash? If income investors are worried about the erosive power of inflation, they may prefer to look at delivering a ‘real’ return, rather than a nominal. Some assets have historically protected investors from inflation, by rising at a similar or slightly higher pace than prices in the broader economy over the long term.

Equities have the edge

By their nature, equities can be considered to deliver a real return. When you buy an equity such as a listed investment trust, you are buying a share of that company’s current and future profits. Company profits have historically demonstrated an ability to keep pace with inflation, because individual businesses can pass on price increases to their customers. This is known as pricing power, which tends to become a highly prized investment characteristic when inflation is high.

As a result of this pricing power, the long-term record of returns delivered by equities is impressive. For example, the real return from the UK stock market since 1900 has been 5.3% per annum¹. Of course, investors must accept a higher degree of volatility from equities, but the long-term reward for tolerating that volatility suggests that it is worth it.

Meanwhile, the yield available from some regional stock markets is also very enticing, even when compared to interest rates. Indeed, at 4.3%, the dividend yield on the UK stock market is still higher than official interest rates. Yields in some parts of Europe and the emerging markets, particularly Asia, also look attractive.

Source: Morgan Stanley as at 31/12/2022
Past performance is not a reliable indicator of future results

Real estate for real returns

As the name suggests, real estate is a real asset. The income from commercial real estate can provide investors with reassuring protection against high inflation. Rents in the EU are generally indexed to inflation and while there is no explicit link in most UK leases, commercial rents in the UK have kept pace with inflation over the long term. That said, it should be noted that commercial real estate values and returns are also influenced by interest rates, and a rise in interest rates at a time when the outlook for the economy is deteriorating could lead to a fall in values, even if rents are rising. This explains why many real estate investment trusts are currently available at steep discounts to their net asset value, which in turn should help shield investors from the capital risk – the bad news may already be in the price.

Like in equity markets, the yield available on real estate assets looks enticing for income investors. Yields of over 7% are currently possible from 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.

Investment trusts and Real Estate Investment Trusts (REITs) for income

Investment trusts are often seen as an attractive route to market for income investors, because of their ability to smooth the flow of income to their shareholders. Investment trusts can retain up to 15% of their net income generated each year to build up reserves which can then be used to smooth out dividend payments, allowing them to maintain or grow their payouts even in volatile market conditions. REITs can retain up to 10% of their aggregate property rental business profits, as calculated for tax purposes, for similar reasons.

Schroders has a range of investment trusts which aim to fulfil the needs of income investors, as we explore below.

Schroder Oriental Income Fund

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 in recent years.

Schroder Oriental Income (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. The portfolio is focused on companies with solid balance sheets, resilient earnings, and strong income and capital growth potential. With a yield of 4.5%, this trust has delivered dividend growth each year since its inception, which highlights the value of ‘dividend smoothing’ for investment trusts. The trust is also recognised as a ‘Next Dividend Hero’ by the Association of Investment Companies (AIC.)

Schroder Income Growth Fund

Schroder Income Growth (SCF) is managed by Schroders’ Head of UK Equities, Sue Noffke. This trust has raised its dividend every year since its launch in 1995, and its rate of growth has outpaced inflation.

The portfolio may invest anywhere across the UK market cap spectrum and is currently biased towards larger companies, where companies derive most of their revenues and profits from overseas. The sterling value of these international (primarily dollar-based) earnings, is particularly attractive at the moment as a result of the relative weakness of sterling against the dollar.

There is also an attractive exposure to small and mid-sized businesses within the portfolio, which looks capable of delivering a rising dividend stream. By blending income from different parts of the market, the trust currently yields 4.6% and the investment team is confident of continuing to deliver dividend growth that outpaces inflation over the medium term. The trust has been awarded AIC Dividend Hero status, which represents investment companies that have consistently increased their dividends for 20 or more years in a row.

Schroder Real Estate Investment Trust

Schroder Real Estate (SREI) seeks an attractive income with capital growth potential from a portfolio of UK commercial real estate. Managed by Nick Montgomery and Bradley Biggins, the strategy is to own and actively manage a diversified portfolio of properties located in the UK’s ‘winning cities’, which benefit from higher economic growth than the country as a whole. The Company has a fully integrated sustainability approach, with expertise to reposition assets to meet evolving occupier requirements. The Company is also differentiated by having the lowest cost, longest duration, debt in its peer group.

Currently, the portfolio is focused on multi-let industrial estates, retail warehousing and offices in winning cities such as London, Manchester and Edinburgh. Following recent dividend increases, the shares yield an appealing 7% and the team’s dynamic approach to portfolio allocation and active asset management provide the means to generate a sustainable rising income, as well as capital growth across market cycles.

Schroder European Real Estate Investment Trust

Similarly, Schroder European Real Estate (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 sensible long-term investment strategy.

The trust was launched in 2015 and is managed by Jeff O’Dwyer, who is supported by a large team of multi-sector real estate professionals, located in key hubs across Europe. Its high quality diversified property portfolio looks capable of delivering a reliable income stream alongside potential for long-term income and capital 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. As at 20 March 2023, the shares yield c.8% and an attractive discount to NAV.

Source: AIC as at 20 March 2023

*Source: Schroders. Reflects the Net LTV as at 31 December 2022, this is the value of external loans unadjusted for unamortised arrangement costs, less cash held expressed as a percentage of the market value of the property investments as at that date.

Conclusion

With UK interest rates at their highest level since 2008, cash savers are finally being rewarded with a return on their deposits again. But this still isn’t enough to protect savers from the erosive power of inflation. Fortunately, there are other options and Schroders has a range of investment trusts offering an attractive starting income and the potential for inflation beating growth over time.

¹ Dimson, Marsh, Staunton - Credit Suisse Global Investment Returns Yearbook 2022

Fund Risk Disclosures

Schroder Oriental Income Fund Limited

Emerging markets risk: Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty and operational risk.

Currency risk: The company can be exposed to different currencies. Changes in foreign exchange rates could create losses.

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 invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

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.

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.

Schroder Income Growth Fund

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.

Gearing risk: The company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

Schroder Real Estate Investment Trust

Investments in real estate are relatively illiquid and more difficult to realise than equities or bonds. Yields may vary and are not guaranteed. The use of gearing is likely to lead to volatility in the Net Asset Value (‘NAV’) meaning that a relatively small movement either down or up in the value of the Company’s total assets will result in a magnified movement in the same direction of that NAV.There is no guarantee that the market price of shares in Investment Companies such as SREIT will fully reflect their underlying NAV. The value of real estate is a matter of a valuer’s opinion rather than fact.

The trust may be concentrated in a limited number of geographic regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up or down, which may adversely impact the performance of the funds.

The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the assets purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

Schroder European Real Estate Investment Trust

Investments in real estate are relatively illiquid and more difficult to realise than equities or bonds. Yields may vary and are not guaranteed. The use of gearing is likely to lead to volatility in the performance of the Net Asset Value (‘NAV’) meaning that a relatively small movement either down or up in the value of the Company’s total assets will result in a magnified movement in the same direction of that NAV. There is no guarantee that the market price of shares in Investment Companies such as SEREIT will fully reflect their underlying NAV. The value of real estate is a matter of a valuer’s opinion rather than fact.

The trust may be concentrated in a limited number of geographic regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up or down, which may adversely impact performance of the funds.

The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the assets purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

The trust can be exposed to different currencies. Changes in foreign exchange rates could create losses.

Important information

This information is a marketing communication.

This document does not constitute an offer to anyone, or a solicitation by anyone, to subscribe for shares of any of the above referenced Investment Companies (Schroder Income Growth Fund plc, Schroder Oriental Income Fund Limited, Schroder Real Estate Investment Trust, Schroder European Real Estate Investment Trust) Nothing in this document should be construed as advice and is therefore not a recommendation to buy or sell shares.

Any reference to sectors/countries/stocks/securities are for illustrative purposes only and not a recommendation to buy or sell any financial instrument/securities or adopt any investment strategy. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions.

Past Performance is not a guide to future performance and may not be repeated.

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 investments to fall as well as rise.

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Issued in April 2023 by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU.

Registration No 4191730 England. Authorised and regulated by the Financial Conduct Authority

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.