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Where should you turn for income?

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04/02/2013
After four years of rock-bottom interest rates, the risks associated with traditional income assets have changed.

Amazingly, it will be four years in March since UK interest rates hit their record low of 0.5%, where of course they have remained ever since. As a result of this, investor appetite for all things income has increased dramatically in the past 12 months or so; the surprise being that it took the best part of three years of rock-bottom returns from bank and building society deposits, coupled with stubbornly high inflation, for the flood gates to finally open.

However, somewhat worryingly, it appears to be the fixed interest markets and, in particular, corporate bond funds that have been enjoying the vast majority of inflows. I say worryingly because, like gilts, credit has enjoyed a bull market for well over two decades, to the point where investors have never been paid less to own this particular asset class.

As I see it, the income conundrum comes in two parts. Firstly, there is a clear issue with the lack of yield from traditional income producing assets, such as cash, government bonds and now large parts of the corporate bond market.

Secondly, and of much more relevance, are the demographic changes taking place before our eyes. Yes, the retirement age may slowly creep up, but the fact remains that the current generation will be retired considerably longer than previous generations. It is for this reason that attitudes to investing in retirement need to change.

The textbooks tell us we should take less ‘risk’ with our investments as we get older and, while this seems logical, it is perhaps the whole concept of risk that requires greater scrutiny.

Cash

Starting with cash, this is naturally seen as a risk-free asset and, of course, in nominal terms this is true. But how low-risk is cash if your overriding investment requirement is to produce a decent income? The investment world is obsessed with volatility these days and surely one of the most volatile assets from an income perspective is cash?

Pre-financial crisis in September 2008, the UK base rate stood at 5%. All things being equal, this provided an annual income of around £5,000 on a £100,000 investment. Today, the return on that same investment has collapsed to £500. If that is not a crash I don’t know what is.

 

The point I am trying to make is that if your requirement is income, investing cash is one of the most volatile ways of achieving this and, in the current climate, totally unsuitable for all but the most short-term investors.

Fixed income

Aside from cash, investors have traditionally looked to the fixed income markets to produce an income. However, the problem with this, to me, is in the ‘fixed’ bit. Hands up who is prepared to take a pay freeze for the next 15 years or so? Not many takers I suspect. However, for anyone retiring today with an average life expectancy and investing in conventional gilts, that is exactly what they are doing.

At a recent seminar, someone in the audience commented that inflation in the UK was not really a problem and I think that was probably the consensus view. However, has anyone looked at the impact of even 2% annual inflation (which is the Bank of England target) over 15 years, let alone the rate we have seen in the past few years? The results are quite frightening.

So, sell your equities to buy gilts? No way. Looking at the current yield on the UK stock market compared with that on gilts, that would be the same as accepting a 50% reduction in pay and then freezing it for the rest of your life.

Equities

So this leads me nicely to what I see as one of the best asset classes for income: our friend, the equity. Why? Well, quite simply because shares have more than proved themselves over the years as an asset that is suitable for investors who require income.

Needless to say, the capital will be volatile, but the volatility and reliability of the income stream (as well as the ability to grow the income) is much more important.

In summary, we need to dismiss the ‘one size fits all’ style of investing that has crept into our industry during recent years. The strategy for someone looking to accumulate capital (whatever their age, attitude to risk, or timeframe) has to be different to someone who is no longer looking to accumulate capital but rather draw an income and, I suspect, wanting to grow that income over time.

David Hambidge is a fund manager at Premier Asset Management

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