7 ways to preserve income in an inflationary environment

Inflation has become the big bad wolf for modern income investors, but it doesn’t need to be. Does it create extra challenges? Of course, but to be fair, all points of the market cycle bring their own problems. In this cheat sheet, I go through the ins and outs of income investing and share tips from some of Australia’s top fund managers.

What is income investing?

Income investing identifies investments that generate regular returns for investors over time used as income. This may be on a quarterly, half-yearly or annual basis. Asset classes that are typically used as income assets include fixed income such as bonds, private credit or debt, real estate or even equities where dividends are used for income.

These types of investments often sit under the ‘defensive’ component of a portfolio, with the aim to buffer you from volatility in sharemarkets. However, given equity dividends can form part of an income strategy, you may still find this in a growth portion of a portfolio.

How do you identify investments for income?

There’s a few parts to this so strap in – and fair warning, speaking to professionals, be it fund managers or financial advisers who specialise in income investing might be a better idea for your long term finances than a DIY job.

Many investments offer an income and there are varying levels of risk involved.

There’s fixed income where you invest in bonds that typically offer a coupon payment on a regular basis and then at maturity (a set end date), you receive the principal amount you invested back. Bonds come in all shapes and formats. There are fixed interest rate bonds which offer the same coupons regardless of whether the cash rate rises or falls, floating-rate bonds which move with the cash rate or inflation-linked bonds which move with inflation so their values can adjust too.

There’s real estate where you might generate a rental return – think a different scale to your personal investment property. Real Estate Investment Trusts (REITs) typically invest in a range of commercial properties such as offices or shopping centres and investors will receive a portion of the proceeds from rent.

Term deposits have some similarity to fixed income in that you deposit an amount with a bank or other financial institution which agrees to pay a set interest amount on your deposit for an agreed period of time.

Company shares might generate income in the form of dividends – but not all companies pay dividends so when choosing shares for dividends, you’ll need to look at factors like the history of dividends paid by the company, revenue streams and forward projections of dividends.

Private debt or credit can also be a source of income. This is where private or unlisted companies take out loans from a company or individual and will make repayments with interest. This form of investing is typically the domain of institutional investors but retail investors who are interested can look at managed funds that invest in this realm.

Investing during rising inflation

Income investing can be a challenge in periods of rising interest rates and inflation for a range of reasons.

1. The value of your investment or the regular income you receive may be less in real terms as a result of inflation. Think of it in terms of your groceries. Say $2 buys you 1L of milk today but inflation is rising. Next year, $2 might only buy you 750ml of milk.
2. The value of certain investments, like fixed interest bonds, will go down with rising interest rates. A very simple way of thinking of it is such: you are offered a fixed interest bond that pays a coupon of 0.25% and the official cash rate rises today to 0.75% - will you pay a premium price for it? The answer is probably not, you’ll pay less for it than you would have when the cash rate matched the coupon and far less than had the cash rate been lower than the coupon rate.

Don’t start shedding your allocation yet though.

The value of your bonds are mainly a concern in periods of rising interest rates and inflation if you are planning to sell your bonds before they reach maturity where you’ll receive the principal sum back – or if the coupons are not going to be enough to sustain you as inflation rises. It’s a question of whether you are diversified enough across your income bearing assets to manage the coming markets.

7 tips to preserve income in an inflationary environment

Depending on who you talk to, and what their speciality is, you’ll get different advice – so I’ve compiled tips from a range of investment managers below.

1. Floating rate notes

If you’re investing in fixed income, there’s a few things to look at. Floating-rate and inflation-linked bonds – you can think of floating-rate as being similar to the variable interest rates on a home loan, they move as the cash rate moves so it can be a buffer for your income needs.

“On a floating rate note, the coupon adjusts every quarter. So you don't see that price action on the downside as yield curves start to sell-off. You do, however, see decreases in price on floating rate notes as spread duration moves, but that again is a different level of risk.” - Simon Mullumby, State Street Global Advisors

2. Reduce exposure to duration

Aim for shorter duration (this is a measure often quoted by fund managers and represents sensitivity to interest rate movements.

“One way it may be prudent for investors to consider bonds is to shorten the duration of their fixed-term bond investments to mitigate the impact of rising interest rates and target higher-rated bonds to mitigate credit risks. The bonds with the greatest duration risk are long-end fixed bonds.” -  Cameron McCormack, VanEck

3. Actively manage maturities regardless of inflation or interest rate activity.

"Returns on bonds can be further increased when bonds approaching their maturity or call dates are reinvested ahead of time. Over the life of the bond, as the length of time to maturity gradually shortens, the credit spread and risk-free rate both decrease (all things being equal) as duration and credit risk are gradually priced out. With this, the bond’s original yield moves lower, causing the bond price to rally.” - Jessica Rusit, FIIG Securities

4. Property has value in this market too – but think beyond simply residential property. 

“What investors need now is shelter from inflation – and that means yields or total returns of 5% plus as a hedge against rising prices in the economy. Property – both equity and especially debt – can deliver those returns and that protection if you know where and what to look for. There are sectors of the property market that we believe will be resilient to rising inflation, such as residential assets (including build-to-rent) and assets that rely on patronage, such as retail, accommodation and hospitality as spending increases in line with rising wages.” - Andrew Schwartz, Qualitas

5. Real Estate Investment Trusts (REITs) with inflation protection mechanisms

Diving further into this, REITs might offer a solid answer to investors according to Rob Rayner, RF CorVal. 

“With inflation rising, commercial real estate is generally well-positioned to capture income growth because of the existence of inflation protection mechanisms. These might include features like annual fixed or CPI-linked rental reviews and also expense pass-throughs.”

6. Private credit and debt markets are becoming more accessible

Retail investors needn’t shy away from private credit and debt either. While this has traditionally been the domain of wholesale and institutional investors, retail investors can typically access this asset class through various managed funds.

“This is a particularly good time for private debt funds, which are able to reprice both base rates and risk margins to the benefit of the funds and their investors.” Andrew Schwartz, Qualitas

Similarly, Urs Wietlisbach, Partners Group, says, "in this environment where we have increased interest rates, a long-term bond doesn't make sense because the valuation will drop. Private markets are all based on floating rates, so this is great. It even helps us on the returns."

7. Dividends still have a role to play

Last, but certainly not least, equities with dividends are still important in inflationary environments.

Hugh Dive, Atlas Funds Management, notes that certain sectors like consumer staples or regulated infrastructure firms such as tollroads where tolls increase with inflation provide continuing opportunity for investors.

“When we’ve seen the tightening policies in the past, people tend to eat at home. They’ll shop at Woolworths and Coles, and at Dan Murphy’s for their bottle of shiraz, but they’re not eating out as much.”

Dr Don Hamson and Dr Peter Gardner from Plato Investment Management recommend investors look at the sustainability of dividends – that is, which companies are likely to consistently pay dividends at a particular level.

“When looking at individual stocks, those in more defensive industries have inherently more sustainable dividends given their earnings are less cyclical. Thus, now they are through their COVID-boosted earnings, Woolworths and Coles rank highly on dividend sustainability (though their yields aren’t particularly large)."

"Wesfarmers, JB Hi-fi (ASX: JBH) are more defensive than people think given our demand for Bunnings and also in the digital world we live in, electronics have become more of a staple than a discretionary as they have historically been regarded. So, both Wesfarmers and JB Hi-fi also look like sustainable long-term dividend payers. Telstra should also be another sustainable dividend payer into the foreseeable future, assuming that competition doesn’t ratchet up in mobile (which is not our expectation).”

Conclusion

Income investing in inflationary periods doesn’t need to be as challenging as it sounds –if we put all the advice from the experts together, a fair portion of it comes down to diversification not just across your assets but within your assets. If you are interested in more information about any of the investment managers and their strategies listed in the article, you can subscribe to their wire by clicking on their names or companies. You can also search for a range of investments here.

This article is part of our Investment Guide series. If there is a topic you would like to learn about next, please leave a comment below.