The high yield portfolio strategy has attracted a fair amount of criticism in the last couple of years. Stephen Bland offers his views.
In a bear market like this, the high yield portfolio (HYP) strategy hasn't exactly been short of critical comment. If people decide to have a go at it, they naturally will do so during a period of poor performance.
Back in time
I'll mention some facts first, based on my HYP1 which was the first public portfolio I set up on the Fool back in 2000 for an investment of £75,000 split equally by £5,000 into each of fifteen shares. It is non tinkering so that changes arise only when there is mandatory corporate action of which there has been a lot over the years. Its eighth year to November 2008 produced record income of £5,040, up 46% in the seven years since the first year's income of £3,451.
The capital had fallen substantially since 2007, but in November 2008 it was still slightly above cost with a gain of 2.4% at £76,825. For comparison the FTSE100 at November 2008 was down 33.4% in the eight years since HYP1 commenced. I make that an outperformance of around 53.8% on capital alone excluding income. On top of that the higher income than the 100 index would have boosted the comparison in favour of HYP1 on a total return basis even more, for those that wish to look at it that way.
I think this is not bad even though the capital in my view as I have stated repeatedly is very much of secondary concern. I know some people don't always see it that way, especially critics of the strategy, so in the process of refuting their repeated claims about how bad an idea they think this is, those are the facts.
The current value is a little higher at £79,051, though it has actually dipped below cost at the worst stages of the last year or so. At the risk of stating the obvious, a portfolio of shares, any shares, has to fluctuate, can easily go well below cost and the investor has to be able to tolerate that.
Income takes a hit
For the forthcoming year to November 2009, the income of HYP1 will take quite a hit due to the prevalence of reduced and suspended dividends by such a wide range of companies. My rough guess based on forecasts is that it will be down by about 35% on 2008, giving an estimate of £3,300 or so which is slightly below the first year's income. On the capital value at November 2008 of £76,825, that represents a forecast yield of some 4.3%.
Okay that's the current state of play on HYP1 and on capital it sees off the critics I'd say. And it's the critics who go on about the capital, even though that was never the principal thing. To date, it's beaten a bank deposit slightly and the index substantially.
Harder to answer is the projected income fall because income is the primary reason for HYPs. My response is to ask what income alternatives there are for an ordinary investor which offer similar risk and liquidity etc. Looking at a popular safe income investment like bank deposits, the return has fallen very much further. Depositors in need of income would be delighted if it was down by only 35% instead of the more likely 80% or more in some cases. Actually, interest rates on a large number of accounts are now as near zero as makes almost no difference.
In a recession many companies will cut dividends. The current one is particularly severe in that respect. But what also happens that is that interest rates fall too as governments try to stimulate demand. The two events of dividend and interest cuts are likely to go hand in hand.
The difference is that the sector diversification of HYPs has a moderating effect on dividend cuts. Even in these times not all companies cut payouts by the same proportion and indeed many have made, and are forecast to continue, increased dividends. The effect is that portfolio income is nowhere near as badly affected as the worst shares in it. I'm not saying that it is impossible for every single company in an HYP to suspend dividends and give you zero income, anything could happen, but it is extremely unlikely.
What's the alternative?
Naturally it's no fun to see your HYP income fall but compared with the alternative of what may be perceived as safer income from bank deposits, HYP income has held up reasonably well in these very tough circumstances. You can't say that about interest.
The other point on this comparison is the relative volatility of interest rates compared with the far more stable HYP income. Over time interest rates are all over the place, the range is very wide. A few years ago interest on a deposit account was several times what it is now. HYP income does not fluctuate by more than a fraction of the range seen in interest. Volatility is one way of looking at risk so on this basis deposit interest is actually far riskier than HYP income, though the trade off is that the capital is stable with the former.
Making the comparison even worse, outside of a tax shelter interest is taxed at your marginal rate whereas almost all UK dividends are tax free to basic rate payers and suffer a lower imposition than does interest for higher rate payers.
It's hard therefore to see how HYP income, can be criticised on a comparison with bank deposits for the income seeker.
Thus the evidence so far, and at eight and half years we haven't hit the really long term yet with HYP1, is that on both income and capital it has stood up fairly well given that I am measuring it at a really bad time. I would have preferred it if the HYP income was not hit quite so hard but I think my forecast of something like a fall of 35% will be fairly typical of portfolios for this year. That should recover fairly smartly as those companies which suspended dividends recommence payouts in due course.
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