"Wealth is not his that has it, but his that enjoys it"
"Wealth consists not in having great possessions, but in having few wants"
"Time is the most valuable thing a man can spend"
- Laertius Diogenes
"The glow of one warm thought is to be worth than money."
"I don't care too much for money for money can't buy me love"
- The Beatles
"Simple, genuine goodness is the best capital to found the business of this life upon. It lasts when fame and money fail, and it is the only riches we can take out this world with us."
-Louisa May Alcott, Little Men
"And though I have the gift of prophecy, and understand all mysteries, and all knowledge, and though I have all faith, so that I could remove mountains, and have not charity, I am nothing."
"Not he who has much is rich but he who gives much"
"Life is what happens to you while you are busy making other plans"
"I pity that man who wants a coat so cheap that the man or woman who produces the cloth shall starve in the process"
Investing for Income Options in a Low Interest Rate Environment
- History of Interest Rates
- Income Generating Investments Available
- Fixed Interest Investments
This is a guide aiming to help investors who are primarily looking for income from their investments and savings, as opposed to capital growth. In this respect financial planning and investing is largely about finding effective ways of providing income from any capital employed. Income may mean different things in different people’s hands so we need to be careful about employing broad brush statements to this quest, however across the board any means we can find to improve income prospects should be pursued. Our objective is to help you find the best income solutions in the current low interest rate environment, regardless of your position relating to the risk you are looking (or able) to take with your capital, your wider objectives or your tax position. We aim to cover each possible position you may be in at the current time within these pages and show you how you can get a decent income generated even though interest rates are at such a low level.
The History of Interest Rates
It is commonly accepted and understood that today’s interest rate (late 2016), measured by the Bank Base Rate of 0.25%, is a historical all-time low. But just how unusual is this current position and how does it look against a longer term history of interest rates in the UK? Below Graph A shows interest rate movements over the past 40 years: This clearly shows how low interest rates are in comparison to the longer term trend and how unusual, indeed unprecedented, this level is. Rates are actually at their lowest for 300 years.
To help with a further view we can now show on Graph B how inflation has moved over recent years. Since 2008 nearly all of the period since has entailed negative returns for savers, savers are losing money in real terms. This is one of the longest periods of real negative returns since records began. There is no obvious sign this trend is set to reverse any time soon.
The implication for savers is clear: savings accounts are in a poor position and no longer represent a viable home for savings which are required to produce an income. Compare this with 1990 for example, when savings accounts would produce interest rates of around 10%. At that point savings accounts were able to generate the income most savers needed and required. The interest rate level is expected to return towards its average at some point and when this occurs savings accounts may once again become a part of the income producing landscape. However there is no indication that any increase is likely in the near future or short term: savers cannot wait indefinitely and income portfolios need to be constructed based on the known facts of today’s rates and levels.
The Income Generating Investments Available To You
There are many different investments that generate income and the good news for income investors is that many of these are capable of providing much higher income levels than a savings account. Furthermore, some of these are either unaffected by the general base rate or may even benefit from them. Unfortunately these alternatives do not necessarily have the same level of risk on the capital invested. This means investors have to pay careful regard to the risk/return position on any investment used to produce an income. There are four main ‘income generating’ investment options from four major asset classes:
- Savings Accounts (normally described as ‘Cash’)
- Fixed Interest Investments
We will examine each in turn.
These are bank accounts, building society accounts and other cash accounts, for example, National Savings. As an asset class they are known as ‘Cash’ and their characteristics are that they offer a risk free home for the capital placed into them, in return for an interest rate payable. The level of interest payable will be closely linked to the general base rate. Although described as risk free they do have some risk in the sense that (a) when interest rates are lower than inflation the saver will be losing capital value in terms of the purchasing power of their money: the inflation rate will be eroding the saver’s capital (b) there is always the risk that the bank or building society will default/fail and capital could be lost as a result – however in the UK there are substantial guarantees in place to protect against this. In all other respects it is accurate to consider Cash accounts as risk free.
WHEN INTEREST RATES ARE LOWER THAN INFLATION THE SAVER WILL BE LOSING CAPITAL VALUE
Fixed Interest Investments:
There are many types of investment that will fit into this category, we will consider just a few within this document to highlight the main features and factors that exist. The most popular example of a fixed interest investment would be government bonds. In the UK government bonds are known as ‘Gilts’ in the US as ‘Treasuries’. They are simple to explain: the government issues a bond and investors purchase them, handing their money to the government. In return the government ‘promise’ to pay the money back at a fixed point in time, in the meantime they pay an annual rate of interest. For example, a 10 year gilt may be issued offering an interest rate of 4.5% per year. This means that an investor subscribing to such an issue would subscribe a sum (say £10,000) and would receive 4.5% per year in interest (£450) knowing they would get their capital back (£10,000) 10 years later. Government bonds tend to offer slightly better rates than cash, mainly to incentivise investors to take the additional risk that they pose. Bonds of this type are considered riskier than cash because they are a promise and if the government fails to meet their promise, capital could be lost. This can and does happen as has been evidenced by many governments worldwide over time (such events are known as ‘defaults’). The general trend is that the ‘safer’ the government, the lower the rate of interest they will have to offer. This is why there has been such a focus on credit ratings – because it is perceived that the credit rating indicates a sign of the strength of the issuing body. A good rating indicates they should be good for their promise, a low rating makes it less likely.
The other big fixed interest ‘instrument’ is a corporate bond. A corporate bond is virtually identical in structure to a government bond except they are issued by companies (hence, the name). They will typically pay a higher rate of interest than a government bond, simply because they are another notch up the risk scale. Companies are more likely to default than a government, as a general rule of thumb. Bonds can be traded – they do not have to be bought on issue or held to maturity. They can be bought and sold throughout their period of time between these two points. However the price of a bond can fluctuate throughout the period and this can mean that bonds have a risk to the investor’s capital. There are many other fixed interest investments, an example would be Permanent Interest Bearing Shares (PIBS) issued by Building Societies. As their name implies strictly speaking these are shares however their structural nature is more akin to a bond. PIBS pay a fixed rate of interest (an income) to investors and this income is generally fixed but unlike bonds they have no redemption date, although there is normally a cancellation date which allows the Building Society to cancel them. PIBs can be bought and sold on the stock market. They are not covered by UK compensation schemes. Although they can look attractive in terms of the fixed income payable and are often considered low risk, these other factors mentioned above need to be taken into account and balanced against the possible benefits.
Shares in companies will normally offer investors the chance to receive dividends. Dividends are paid out of the profits made by a company. Dividend payments are most often paid to investors twice per year and will be dependent on how well the company performs. Buying shares in a company is a risky venture because the share price can fluctuate and the dividend payment may also go up and down and possibly disappear altogether. A company could go out of business – making the investment a high risk. The upside however is that dividend payment levels are generally disconnected from the base rate and tend to have a higher (sometimes much higher) percentage level than cash alternatives. There is also the prospect of a decent growth in the amount of dividend payable year on year, offering the possibility that the income level can keep rising. The company share price could also rise – which could provide a ‘win, win’: a higher income plus a profit on the capital amount invested.
Property can generally be classed into two separate categories: residential property and commercial property. A residential property can be bought to let out with the rental income acting as the basis for an income payment to the investor. Likewise a commercial property (an office, factory, warehouse etc.) can be bought and owned in the same way, with the rental being paid by the tenant (the business that rents/leases the property) being collected as an income. Rental income is unlikely to be tied to interest rates, the level is probably going to be much higher in the current environment.
As with shares there is an issue around the capital value of the property owned, which could go up or down – similarly the rental income could be unreliable or fall. Therefore property investments have the same hallmarks as shares: offering the potential for much higher income than cash, the potential for growth in the capital value of the asset, but inherently much riskier overall. Property has another risk factor: it is deemed ‘illiquid’. This means it can be difficult to sell a property quickly (and in very bad markets, possibly at all), leaving investors stuck if markets turn and they wish to exit their investment.
THE GREATEST CHALLENGE FOR INVESTORS IS [DECIDING ON] ...
These are the main asset areas and the characteristics of each: the areas offer different income prospects, different positions with the risk attached and variable prospects on the potential capital return. The core understanding of each investment and their structural nature is a crucial start point, however there needs to be some serious application towards the details, because it will be the details which provide the solutions to anyone seeking to improve their income and to get a good income, almost regardless of the prevailing environment. There are many different individual possible investment types that investors may use in creating an income portfolio. However the greatest challenge for investors is not the choice of these individual types but the construction of the right asset allocation mix to meet their needs.
THE RIGHT ASSET ALLOCATION MIX TO MEET THEIR NEEDS
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We can help you plan your investments and generate income even during low interest environments.
Alan Moran is one of the most highly qualified advisers in the UK. He became a Certified Financial Planner in 1995 and he was one of the first Chartered Financial Planners in 2005. He is a Chartered FCSI, a holder of the IMC certificate and member of CFA UK. His expertise has been called upon by The CII, The IFP, The Kinder Institute, and others, where he has trained and examined other financial advisers.
Readers should not rely on, or take any action or steps, based on anything written in these guides without first taking appropriate advice. Interface Financial Planning Ltd cannot be held responsible for any decisions based on the wording in these guides where such advice has not been sought or taken.
The information contained in these guides is based on legislation as of the date of preparation and this may be subject to change. We will aim to keep them up to date but inevitably there may be a time delay so current legislation should always be checked.