Fran Radano, manager of The North American Income Trust

• The US Federal Reserve is likely to keep rates higher for longer, supporting more defensive positioning
• Income seekers have a wider range of options this year
• It is a better environment for ‘value’ companies, rather than high growth areas such as technology

2022 created a new environment for income investors. After a decade where income was scarce, the US Federal Reserve (‘Fed’) raised interest rates eight times over the year. Financial markets saw a major adjustment. In bond markets, there was a significant rise in yields, in stock markets, high growth areas came under pressure, while ‘value’ areas thrived.

With 2023 well underway, the process of adjustment is largely complete. Investors continue to speculate about a potential Fed pivot that would see it ease its tightening policy, but it is increasingly clear that the past decade has been an anomaly. Interest rates are likely to remain at more normal levels by historic standards.

We believe financial markets are still too optimistic about the prospect of a pivot from the Federal Reserve in the second half of this year. The central bank will almost certainly keep rates at a higher level. It doesn’t want to make another error by cutting too early and keeping inflation around. There are still significant pressures in the labour market and wages are rising. If there is a pivot, it is more likely to be because of significant bad news in the economy so may not be good for markets.

Market impact

This leads us to a defensive tilt in The North American Income Trust portfolio. Rather than taking sector bets, we are looking for the strongest and more defensive options within each sector. Higher interest rates will push investors to look more closely at valuations. When the cost of capital is negative and companies have unlimited ability to tap capital markets, valuations don’t matter as much, but with the Fed Funds rate at 5%, investors care about profitability once again.

We see ongoing support for more ‘value’ areas of the market – well-priced companies with strong balance sheets and cash flow. Given the strength of some growth areas over the past decade, there is still considerable adjustment to be made in spite of the outperformance of value companies last year. Growth companies still appear highly rated, even where their outlook is uncertain. The market does not appear to be factoring in the impact of a potential recession for many of these companies.

Buoyant outlook for income

The outlook for income is buoyant. There is certainly greater competition for capital now with higher quality bonds yielding 5-6%. Dividend portfolios tend to yield 3-3.5%. However, income strategies – including ours – strive to combine growth and income. In the Trust, we have limited exposure to ‘bond proxy’ areas. These are areas such as utilities that pay a reliable dividend year after year, but where that dividend doesn’t grow significantly, giving them bond-like characteristics.

In contrast, many of the companies in our portfolio are growing their pay-outs at 5-10%. We have a progressive dividend policy, so aim to outpace inflation. That has been difficult over the past 12 months but should become easier over time. 

Our portfolio holds 35-40 companies, allowing us the space to focus on companies’ balance sheets, cash generation and conversion. Holding a long tail of companies can dilute the process. It is difficult to have real conviction in 70 or 80 ideas. This focus has helped us deliver real income resilience over time. We only had one dividend cut during the pandemic and it was small. The Trust has reserves of over a year’s worth of dividends.

Every year brings a fresh set of risks. Last year, politics became a factor, as markets had to digest the impact of the mid-term elections. This year should bring less political noise, though there may be some volatility surrounding the debt ceiling, where both the Republican and Democrat parties need to sign off on the national debt.

2022 was a year of significant adjustment. While the stock market still has to face down significant challenges, the prospect of a more certain interest rate environment and weaker inflation should be beneficial. In the meantime, it is a better environment for income investors than it has been for many years.  Given the outlook for valuation and interest rates, dividends are likely to become a more significant part of investors’ total return.

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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