Looking For Income? Could High Yield Bonds Be The Answer?


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The combination of low interest rates and rising inflation means that most savers are earning negative real rates of returns on their cash deposits and the value of their savings is gradually bein

The combination of low interest rates and rising inflation means that most savers are earning negative real rates of returns on their cash deposits and the value of their savings is gradually being eroded. Bank interest is also liable to tax whether you withdraw it or not. In the UK, Moneyfacts calculates that to earn a real rate of return a basic rate taxpayer needs to earn 5.63% interest ? but the average interest offered on easy access accounts is just 0.89%.

While the Bank of International Settlements and OECD have called for the Bank of England to raise its base rate, many economists do not offer much hope for a rise in the near future. The economy is still struggling and minutes for the last Monetary Policy Meeting suggest more quantitative easing could be on the agenda.

Some commentators are wondering if a rise could be delayed until next year, while economists at BNP Paribas have suggested we may have to wait till 2013. Although UK inflation is too high they argue that the problems facing the recovery mean that the BoE will not achieve much by rising rates: ?There is no point in hiking rates to slow the economy ? it?s too slow already and fiscal consolidation will stop it from overheating.?

It is a different story in Europe where the European Central Bank has already lifted its rate and is expected to do so again in its fight against inflation. However if both interest rates and inflation increase there may be little improvement to savers? real income.

In order to maintain the spending power of your savings through retirement, your capital needs to earn enough (after any income has been taken and taxes paid) to keep pace with inflation each year.

High yield corporate bonds are an attractive option for people looking to move money out of cash to earn a better rate of return. Corporate bond funds are particularly useful for retired people since they can provide regular income as well as the potential for capital growth over the longer-term. On the other hand, monies held in a bank account are not exposed to investment risk.

High yield bonds have performed well over the last three years and the asset class still looks promising. Income and capital prospects exceed the downside risks based on market fundamentals and good returns can be delivered. Both income and capital appreciation have contributed to performance and income yields remain generous. They are expected to continue to deliver attractive returns this year, thus providing good inflation protection.

The corporate picture is generally positive. Company fortunes are dependant on the markets they operate in so those operating in weaker economies are obviously more cautious about their outlooks. Nevertheless there has been continued reporting of good corporate results and margin improvements across the board as companies reduce spending and improve efficiency.

This has enabled most firms to remain profitable despite the downturn and over 2010 there was an increasing trend of company results improving on a sequential and year-on-year basis.

This also supports the ongoing low default rates. Defaults were a big concern over the credit crisis and rating agencies painted a very pessimistic picture. As it turned out, however, the default rate was lower than in the previous downturn. The fundamentals for many companies were much more positive than the market priced in.

European defaults have fallen from a peak in December 2009 and at 2.2% are currently well below the long-run average. Recent agency forecasts now suggest default rates in Europe and the UK will be well below the long-term average this year.

Also positive for high yield bond investors is that the fact that it is a growing market. Over the last ten years the European high-yield market has grown from ?16 billion to ?141 billion. There is a healthy pipeline for new issues from both existing companies and new companies to the high yield market.

Another key attraction of high yield bonds is their relative immunity from inflation. High yield has tended to be more resilient than other bonds in periods of high inflation as prices are more sensitive to the credit quality of the issuers than base rate changes. They tend to be shorter dated than investment grade credit and government bonds so they are less affected by rising prices and interest rates.

While an expertly managed high yield bond fund is more than likely to provide higher income than a bank account, investors need to be prepared for some volatility. High yield bonds are expected to offer modest capital appreciation this year, but income will be the focus rather than capital gains. It is worth noting that over the financial crisis the income levels held up very well, even if the capital value was affected. As with most investments, you should look to hold your fund for the medium to longer term

These views are put forward for consideration purposes only as the suitability of any investment is dependent on the investment objectives, time horizon and attitude to risk of the investor. The value of investments can fall as well as rise as can the income arising from them. Past performance should not be seen as an indication of future performance. You should seek advice from an authorised financial adviser such as Blevins Franks Financial Management Ltd.

Blevins Franks Financial Management Ltd is authorised and regulated by the UK Financial Services Authority for the conduct of investment and pension business.

By Bill Blevins, Managing Director, Blevins Franks

28th June 2011

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.