It’s a conundrum for those in the IMA’s UK Equity & Bond Income sector: in a time of depressed bond yields, funds must still hold 20% in fixed income while delivering a yield 120% more than the FTSE All Share index.
Citywire AAA-rated Matthew Rainbird, co-manager of the Marlborough Extra Income fund, has managed to square this circle. His fund offers a historic yield of 4.26%, and has returned 40.5% over the past three years compared with an average of 29.4% from the IMA peer group.
It also boasts the best Sharpe ratio in its larger Citywire Mixed Assets category of 223 funds over the same period, with the fourth best total return.
So how does Rainbird approach the bond hurdle? First of all, he has – like many others – slashed the duration in his fixed income portfolio ahead of any interest rate hike. But that naturally impairs the fund’s income generation, so Rainbird has turned to other instruments.
Chief among these are floating-rate notes and preference shares, at around 9% of the portfolio. Rainbird owns such securities issued by the likes of Investec, Standard Chartered and Lloyds. This explains the fund’s 22% allocation to financials; Close Brothers is the only financial services equity in his top 10 holdings with a 1.1% weight.
‘This gives a steady income stream and, as preference shares aren’t as volatile as equities, helps to provide a greater degree of capital stability,’ Rainbird said. Floating-rate notes also provide protection, he added. ‘As interest rates rise, the income from them will rise and, we believe, there will also be scope for capital appreciation.’
Anxiety about higher interest rates has deterred Rainbird from property too, which represents 0.9% of the portfolio despite its current popularity among income seekers. That has led to elevated valuations in the sector. ‘What is going to happen to those share prices when interest rates rise?’ asked Rainbird.
An aversion to risk characterises Rainbird’s thinking. ‘There is quite a lot of exposure to the London property market,’ he said of listed real estate. ‘Why be drawn into an area where there are question marks?’
Marlborough Extra Income exhibits the lowest volatility in its sector, but he emphasised that ‘this has not come at the expense of returns’. Underlying its volatility profile is its extreme diversification: the £40.5 million fund has 136 holdings.
It therefore sucks in a great many income streams, smoothing returns. As an example of a niche diversifying investment, Rainbird cites Doric Nimrod, the investment trust that leases aircraft to the Emirates. That in itself delivers a steady, uncorrelated dividend flow. But for extra protection Rainbird invests in two of the listed Doric Nimrod funds.
Despite the width and depth of the portfolio, he stresses that he is a buy and hold investor. Marlborough Extra Income’s portfolio turnover rate is 35%. ‘Quality is key because we’re running a low-risk fund,’ he said.
Rainbird additionally argues that excessive churn impairs income generation. ‘If you jump in and out, how will you benefit from rising dividends?’ He suggests Next as a case in point. Marlborough Extra Income first bought the stock when it traded around £18 in 2009; now the retailer’s share price is north of £60.
‘It would have been very easy to jump out and take a handsome profit,’ Rainbird acknowledged. However, he would then have missed the special dividend that Next announced at the start of January; analysts at Peel Hunt have forecast that Next will yield almost 6% for 2015.
This focus on the long term informed his refusal to dump Shell after its profit warning last week, which knocked 2% off its share price in a day. ‘We don’t take kneejerk reactions,’ Rainbird asserted, although he confirmed he will be monitoring progress under the new chief executive. ‘We’re going to have to see whether there are management issues or it is a one-off like they say.’
Elsewhere in Marlborough Extra Income’s portfolio, a growing theme is the potential for mergers and acquisitions. A top mid-cap pick is TalkTalk, which Rainbird notes is now competing with – and undercutting – Sky in the online TV market.
It has now emerged as a possible takeover target. ‘We weren’t thinking of consolidation when we bought it, but that could now be an interesting by-product.’
Similarly, Rainbird is watching Vodafone with interest. The telecoms titan is the largest position in Marlborough Extra Income, and Rainbird plans to reinvest the proceeds he receives from the Verizon disposal in the company.
‘We think the rump of what’s left after Verizon Wireless is potentially undervalued.’ And he believes that that value could be unlocked by more corporate activity, potentially involving the breakup of the conglomerate.