The post-Global Financial Crisis (GFC) era of ever-lower interest rates and quantitative easing placed a premium on traditional income sources. This had the intended effect: it pushed those seeking yield into riskier market areas, whether in European sovereign bonds from countries like Italy or Spain, or in Emerging Market Debt, Infrastructure, or Private Debt. With inflation rising in recent years and interest rates resetting to more normal levels, this equation has reversed – many would argue, in the right way. Yields on traditional government and corporate bonds from quality issuers now exceed the meagre sub-2% levels seen throughout the 2010’s, offering more options to those in search of income.
This shift prompts fundamental questions about the pursuit of income. Is it still worth taking liquidity risks when government bonds may meet income needs? Is equity risk necessary when bonds could suffice?
The bond vs equity debate
The bond-versus-equity debate continues, yet these two asset classes remain fundamentally different, and income generation is one of the clearest distinctions between them.
Bonds, also known as Fixed Income, have a fixed coupon by nature. For the simplest bonds, total return is limited to the coupon plus or minus the "pull to par" (yield to maturity). Income yield is calculated as the coupon rate divided by the purchase price.
Therefore, income yield and yield to maturity can differ, with income-focused investors likely emphasising the former. Equities, on the other hand, offer more flexibility. Companies that pay dividends often follow a set policy, such as a fixed percentage of earnings (payout ratio) or a ‘progressive policy’—aiming to grow the dividend over time when possible.
This is a key difference between equities and traditional bonds: dividends can increase. During inflationary periods, companies with pricing power can raise prices in line with inflation, potentially improving cash flow or balance sheet strength, which may lead to higher dividends for investors.
Deriving income from equities
At a broader level, a debate persists on the benefits of deriving income from equities. One viewpoint argues that dividends received today are returns that will not materialise in the future – capital that cannot be reinvested.
At the extreme, this perspective suggests that dividend-paying companies may be in long-term decline, lacking sufficient growth opportunities. Others contend that paying dividends signals capital discipline: companies understand what they can deploy at an attractive rate of return and return any excess capital to shareholders.
Some suggest dividends provide investors with income while waiting for reinvested capital returns to be recognised by the market.
How to leverage a multi-asset approach
A multi-asset approach can help navigate these challenges. In times of higher income availability, like today, the bond component of a portfolio can play a larger role in income generation, while the equity portion can focus on balanced returns from both income and growth, providing a real return if inflation resurges.
If bond yields fall significantly, equities can serve as an alternative income source, complementing the potential capital gains from bonds.
Learn more about how our AJ Bell Income and AJ Bell Income & Growth Funds offer ‘smoothed’ income returns, so you can navigate the peaks and troughs – all for an OCF that’s now down from 0.65% to 0.50%.
The value of investments can go down as well as up, and your client may not get back their original investment.
Past performance is not a guide to future performance, and some investments need to be held for the long term.
