Investing for income in a time of low interest rates PARTNERS IN MANAGING YOUR WEALTH 1 INVESTING FOR INCOME
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1 Investing for income in a time of low interest rates PARTNERS IN MANAGING YOUR WEALTH 1
2 Contents 3 Introduction 4 Fixed interest 6 Corporate bonds 9 Gilts 10 Equities 13 Commercial property 14 Risk and reward 17 Why St. James s Place? 19 What do I do next? 2
3 Introduction he global recession in which we find ourselves firmly entrenched has brought with it a number of ill-effects, not least of all in terms of rising unemployment and the increasing demands being placed on an individuals income. In this context, the pressure brought to bear as a result of historically low interest rates is unwelcome to say the least. Yet the reality is that interest rates have fallen 90% since September 2008 and many with cash on deposit have seen an equivalent fall in their savings income. It is essential that investors hold a certain amount of cash on deposit as part of their investment strategy, not only to meet cash emergencies and short term income needs but also as part of a well diversified and risk-managed investment portfolio. However, in the current environment it is clear that our money needs to work harder to provide income now and over the medium to long term. This guide aims to provide some potential solutions to this problem. 3
4 Solutions to beat falling interest rates Fixed interest Fixed interest investments are loans made by investors to companies (in the form of corporate bonds) or governments (as gilts). Such investments can be made directly by purchasing individual bonds or gilts, or by investing into a fixed interest fund. Many investors choose to access fixed interest investments via a fund, where their money is pooled together with other investors and looked after by a professional fund manager. This enables the fund manager to invest in a spread of fixed interest holdings which are actively traded and typically not held to maturity. This provides the investor with the benefits of active management and diversification to reduce risk, as well as the ability to receive regular income payments from the fund. During times of economic uncertainty, fixed interest investments often become popular as investors seek the perceived safety of a fixed return. Yet for those considering fixed interest investments, it is also worth remembering that they are not risk-free - their value can go down from time to time and they are affected by inflation, particularly in terms of the buying power of the capital returned when the loan finishes. 4
5 Ultimately, fixed interest investments play a valid role in any well diversified portfolio. As they are subject to the ups and downs of the economic cycle, inexperienced or less confident investors should seek the assistance of an expert to manage their exposure to such investments. Additional detail on each type of fixed interest investment follows. How bond yields work Bonds usually have a nominal or par value of 100 each. But as they change hands in the marketplace, they may be sold for more or less than 100, depending on factors such as the current base rate, the attractiveness of the returns on offer and the remaining term until maturity. The interest rate payable is not necessarily the yield it depends on what you paid for the bond. If you paid 100 for a bond paying 4% (or 4) a year, then it yields 4%. If you paid only 99, you still get the annual 4 interest payment, so its yield goes up to 4.04%. But if you paid 101 it comes down to 3.96%. That explains the counterintuitive fact that when people talk about yields coming down, they mean that prices are going up and vice versa. 5
6 Corporate bonds Companies are often seen as being a higher credit risk than governments (ie they are seen as being more likely to default on the loans made to them) and as such corporate bonds often offer higher returns than gilts. In respect of the current crisis, corporate bond markets are pricing in a level of credit risk (ie the likelihood of companies defaulting on their interest payments) which, in the opinion of many commentators, is not only unlikely, but assumes a worse economic downturn than the 1930s. As such, corporate bonds offer significant value for investors at present, with yields currently at historically attractive levels. Within the corporate bond sector there is a hierarchy of return quite simply, companies with lesser financial strength are considered more of a credit risk and therefore generally offer higher rates of return. Investors can identify those firms that are a higher credit risk by the credit rating given by independent ratings agencies, such as Standard & Poor s, Moody s or Fitch Rating. The table opposite shows the ratings given, with a distinction between investment grade (bonds offering a low credit risk due to the comparatively stable position of the issuing firm) and non-investment grade bonds (where firms are believed to be less financially secure or who have no proven track record). 6
7 Credit Risk Investment Grade Highest quality High quality (very strong) Upper medium grade (strong) Medium grade Non-Investment Grade Lower medium grade (somewhat speculative) Low grade (speculative) Poor quality (may default) Most speculative No interest being paid or bankruptcy petition filed In default Moody s * Aaa Aa A Baa Ba B Caa Ca C C Standard & Poor s ** AAA AA A BBB BB B CCC CC D D Fitch Rating ** AAA AA A BBB BB B CCC CC C D * The ratings from Aa to Ca by Moody s may be modified by the addition of a 1, 2 or 3 to show relative standing within the category. ** The ratings from AA to CC by Standard & Poor s and Fitch Ratings may be modified by the addition of a plus or minus sign to show relative standing within the category. It is important to remember that, whatever the credit risk, corporate bonds typically have a maturity date more than one year in the future, and therefore may not be suitable for investors requiring immediate access to their funds. 7
8 8
9 Gilts Gilts, or loans to the government, have been one of the very few asset classes to rise in value as the recession has become deeper and more pronounced. As a loan made to the government, the chances of default are low the UK government has never defaulted on a payment since the origins of the national debt in 1694 and as such gilts are AAA rated in terms of the security offered to investors. More recently, gilt prices have increased following the UK government s implementation of quantitative easing (essentially the Treasury buying debt, including gilts, as a means of increasing the flow of money within the economy). As prices have gone up, yields - a reflection of income earned in the previous 12 month period - have decreased. Fixed Interest Effective Yields 35% 30% Sterling High Yield Corporate Bonds Sterling Investment Grade Corporate Bonds Sterling Gilts 25% 20% 15% 10% 5% 0% 31/12/ /02/ /04/ /06/ /08/ /10/ /12/ /02/ /04/ /06/ /08/ /10/ /12/ /02/2009 Source: Bloomberg / Merrill Lynch Indices 9
10 Equities Equities, or shares, are investments in companies that are listed on a stock exchange. The value of shares can fluctuate depending on the performance of the company or companies invested in and as such, the value of an investment can go up or down in the short-term. Those investing in companies are entitled to a share in the profits of that company by way of dividends paid to shareholders. Sustainable dividend growth is traditionally seen as a measure of the long term success of a company and it is this that provides the potential for equities to deliver a rising income. Given recent volatility, cautious investors would be forgiven for wanting to limit their exposure to the stock market, yet to do so would be overlooking the long term potential of equity investment. Historically equities have outperformed all other asset classes in the longer term in respect of both capital growth and income paid - although this obviously cannot be guaranteed to happen again in the future. In times such as now, when market returns are more modest and interest rates and inflation are low, investors often turn their attention to high-quality cash generative companies which have a good track record for paying dividends. Much like the property market, equity prices are currently depressed at the time of writing the FTSE100 is meandering around 4,300, significantly lower than at the turn of the millennium when it peaked at nearly 7,000. This means that shares are trading at historically low levels and provide investors with real potential for capital growth. However it is important to remember that over the past 100 years, the returns from equities have not come primarily from capital growth, but from the reinvestment of dividend payments. 10
11 Yet for those requiring investment income to support their everyday living expenses, it may not be appropriate to reinvest the dividends received. In this case, dividend payments can provide a regular income that, over time, has outstripped any income provided by cash held in deposit accounts. The chart below shows how the income produced from a 100,000 investment in the FTSE All Share Index has gradually risen, while returns from cash deposits have more often fallen from one year to the next *. Annual income from 100,000 invested in a Deposit Account vs Equity Investment 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 FTSE All Share Income Deposit Income * Source: Lipper Hindsight. Please be aware that past performance is not indicative of future performance. The value of your investment and the income from it can fall as well as rise. Returns on equities cannot be guaranteed. Equities do not provide the security of capital characteristic of a deposit with a bank or building society. Of course, choosing the right companies to invest in is not easy and putting all of your money into a single organisation is an extremely high-risk strategy. For this reason, investing in an equity fund, where your money is split amongst a range of companies selected and actively managed by a professional fund manager, may be more appropriate. 11
12 12
13 Commercial property Few people have the money to invest directly into commercial property which includes offices, retail outlets, warehouses and industrial premises and with recent reductions in property values, many might think twice about investing in this area. Yet depressed markets offer investors a real opportunity to achieve capital growth in the longer term, and as rental incomes have generally remained firm in spite of reduced property values, the income available from commercial property is also attractive. Perhaps a more convenient way of investing into property is via a collective investment vehicle, or fund, as these provide the ability to benefit from long term capital growth through increased property values as well as from the rental income previously mentioned, without the risk of buying a single property and having all your eggs in one basket. Historically, property markets have tended to perform independently of movements in fixed interest and equity markets, and therefore have the potential to provide returns when other investment types may not be. As such, property investment is a useful tool in ensuring that any investment portfolio is adequately diversified. Income and capital growth achieved through an investment in commercial property 30% 25% Capital Growth Income Return 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% Source: IPD Index. Please be aware that past performance is not indicative of future performance. This information is provided for illustrative purposes only, you cannot invest directly into the IPD Index. Property can be difficult to sell - so you may not be able to sell/cash in the investment when you want to. The value of property is generally a matter of a valuer s opinion rather than fact. 13
14 Risk and reward C learly, to improve the return on your investment by moving outside of cash deposits requires taking additional risk. Yet by carefully combining the different asset types, you can create an investment portfolio that maximises your income possibilities, while controlling risk to your capital and providing the potential for inflation-beating returns that could well exceed those available on deposit. Bank/Cash deposits Provides the security of capital, which is not available with equities or the other asset types mentioned within this guide, from which returns are not guaranteed. Offer investors security and instant access to their capital when required for short term needs. Income will fluctuate in response to changes in interest rates. Inflation will reduce the real value of deposits over the medium to longterm. No potential for capital growth. Fixed interest Increased levels of income are achievable if investors are willing to take a risk with their capital. Most fixed interest investments offer little potential for income growth as the level of interest (known as the coupon) is fixed. The potential for capital growth is limited and investors should be aware that capital losses might occur, particularly in a period of volatile interest rates. 14
15 Equities Whilst in the short-term equities can be volatile, history shows us that they have outperformed all other asset classes over the long-term. Equities also offer the potential for a rising income over the medium to long-term. There is also the potential for significant capital gains. It is possible that the value of an investment in equities and the income from it can fall as well as rise. Commercial property Unless investing through a collective investment vehicle, the minimum investment to access this asset class can be out of reach for many investors without taking on significant borrowing. Commercial property can offer investors higher levels of income than deposits and fixed interest investments. Rent reviews can provide the potential for income growth over the longer-term. When held over the medium to long-term, commercial property may also provide capital growth. The difficulties of buying and selling properties may mean that investors suffer a delay when trying to get their capital back. 15
16 16
17 Why St. James s Place? S t. James s Place Wealth Management are experts in providing solutions that meet the requirements of those investing for income. We offer a broad range of diversified and actively managed portfolios that are structured to meet a variety of income needs and risk profiles. The income solutions that we offer are available through a variety of financial products, including ISAs, unit trusts, investment bonds and pensions. We believe that the best possible return on investment is obtained by using the best possible fund managers. Unlike most wealth managers, we don t employ investment managers ourselves because we recognise that no single investment company has a monopoly on investment expertise. Instead, we carefully select highly respected external managers to run our range of income funds. At the cornerstone of this approach is the St. James s Place Investment Committee which manages the managers on behalf of our clients. With the help of an independent consultancy firm, Stamford Associates, the Committee selects, monitors and, if necessary, changes the managers. Quite simply, this gives you unrivalled access to investment expertise and the opportunity to invest across a range of different investment firms, with the peace of mind that your money is being well looked after. 17
18 18
19 What do I do next? A s an expert in wealth management, a St. James s Place Partner can talk you through the options for investing in equities, fixed interest and property and create a bespoke solution for you. If you are interested in discussing the options available in more detail please contact your St. James s Place Partner. Alternatively, for further information you can call St. James s Place on or visit 19
20 Members of the St. James s Place Wealth Management Group are authorised and regulated by the Financial Services Authority. The St. James s Place Partnership and the title Partner are the marketing terms used to describe St. James s Place representatives. St. James s Place UK plc: Registered Office St. James s Place House, Dollar Street, Cirencester, Gloucestershire, GL7 2AQ, United Kingdom Registered in England Number SJP3168-VR1 (06/09)
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