Investing for Income

18.11.10

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Introduction

Investing to generate income in a Western world dominated by near-zero interest rates has become a key challenge. In the past it has been possible to draw suffici

Introduction

Investing to generate income in a Western world dominated by near-zero interest rates has become a key challenge. In the past it has been possible to draw sufficient income from a number of lower risk assets such as traditional bank deposits or government debt. As a result, it has historically been relatively straight forward to achieve a balance of producing income through fixed income securities in cash, whilst also capturing long-term capital growth and aiming for protection against inflation through equities, property and other assets classes.

These days, however, nominal yields from lower-risks assets traditionally held for income (e.g. cash and sovereign debt) have fallen substantially. As a result, investors had been compelled to assess how, and if, they can maintain previously higher income.

Inflation is now materially above interest rates in many parts of the capital Western world. Therefore the opportunity cost of retaining significant sums on deposit over the medium-term becomes painfully apparent as rising prices erode the real purchasing power of assets over time.

Choices

One has three choices in this new era of low interest rates:

1)Reduce income to face the new reality;

2)Seek alternative sources of income to sustain the higher pay-out levels but at higher risk levels, and thus possibly exposing assets to future investments bubbles.

3)Embrace a total return investment philosophy by withdrawing a set sum regardless of income levels in order to avoid skewing the portfolio in favour of income regardless of capital preservation.

Inevitably a combination of these, taking account of taxes, income, time horizon, capital preservation and risk appetite is usually the preferred outcome. The overriding consideration should be to balance the longer-term risk tolerance rather than trying to pick up on a shorter-term market trends, which can often prove illusory.

Corporate Bonds

When interest rates collapsed in 2008, corporate bonds, after years of earning a reducing yield premium over government debt, began to show a much higher risk premium. However, the panic which followed the collapse of Lehman Brothers and the credit crunch led to panic selling later that year, and the capital value of corporate bonds (in particular high yield bonds) declined considerably. The panic subsided when the global banking meltdown was prevented with governments stepping in to bail out failing banks. Throughout this helter-skelter, the income generated from the corporate bonds held up ? the emotional expectation that economies were about to collapse did not happen. Non investment grade corporate bonds, in particular, did not suffer the predicted high default grades.

Property

Before the crises, commercial property has enjoyed several years of favourable inflows, supported by freely available credit. But the property bubble burst when credit dried up, and many property funds have had to become illiquid with the Fund Managers freezing redemptions.

Equities

Traditionally equities have not been the first consideration when seeking income, but today the equity markets generally are focused more on sustainable dividends proceeds, strong balanced sheets and high levels of free cash flow. This is in stark contrast to market conditions some ten years ago when technology, media and telecommunications stocks traded on very high PE ratios which ignored any dividends or assessment of short-term profits.

Complex Structures

The credit crunch exposed the risks behind the proliferation of complex illiquid and leveraged investments with opaque credit risk. Their weakness became apparent with the capitulation of companies like AIG and its counterparties. The simpler strategies were overlooked and investors and advisers did not sufficiently focus on the underlying risk of the structure.

Inflation

Inflation can have an impact on many asset classes. In a Japanese-style environment of deflation, assets with fixed income yields such as corporate bonds, can become attractive as prices for these securities would be driven higher. In a period of rising (but not runaway) prices, the opposite is true and equities would normally benefit.

Currently there are some disinflationary forces in Western economies caused by spare capacity and higher unemployment, along with rising savings ratios and substantially reduced lending, leading to lower wage expectations. These trends may be masked by higher import inflation and by ?quantitative easing? i.e. printing of money.

Safe Havens

As a result of the printing of money, investors have been concerned about the long-term purchasing power of main currencies. This has been one of the main reasons for increasing investment in physical gold as an insurance policy against economic uncertainty. Gold delivers no income yield, and indeed creates the opposite: holding costs.

Another safe haven in period of financial uncertainty has traditionally been indexed-linked sovereign debt, providing protection from future inflation. However, break-even rates against government debt are unattractive to investors. In other words, there is no positive return over inflation.

Diversification

The merits of the diversification have not been obvious over the past two years, as many asset classes have been highly correlated. However, this would not always be the case (nor indeed was it before).

Conclusion

Seeking income is much more difficult than ever, but if a total return approach is taken, and sensible diversification sought, it should be achievable. As ever, the outcome can never be guaranteed. Seek personal advice from an experienced wealth manager like Blevins Franks.

By David Franks, Chief Executive, Blevins Franks

25th October 2010

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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