Times have changed and an income strategy does not necessarily mean you have to accept a hit to your portfolio’s value – especially if you are in a position to take on more risk with your capital. There are plenty of opportunities available to income-seeking investors and in our Investing for Income series we set out a number of the available options.
FLEXIBILITY AND VERSATILITY
For many investors, an income-generating strategy forms the core of their approach. Some want a portfolio that will provide a regular income stream for them to spend. For others, an income-based approach is a consequence of their attitude to risk, rather than an instigator of their strategy, and these investors might choose to reinvest their income to boost their portfolio’s total return over the long term. Still others might have a core investment strategy that focuses on capital growth, complemented and diversified by an income-generating segment.
Every investor will have their own unique needs – for instance, they might choose to draw the income or to reinvest it for the long term. However, an income strategy can easily be adapted to meet each investor’s changing circumstances as time moves on.
A WORLD OF CHOICE
Whatever your risk appetite, there are a wide range of asset classes and sub-asset classes from which to formulate a diversified income strategy – from government and corporate bonds, through UK and global equities, to property and real estate investment trusts.
FIXED INCOME (BONDS)
Fixed income investments provide a stable and predictable level of income many investors find reassuring. They pay a set rate of interest that does not change, regardless of the prevailing economic environment, and also have a fixed repayment date. Bond prices are influenced by fluctuations in interest rates and the rate of inflation. In addition, corporate bond prices are also affected by individual company or industry news.
CASH: NOT NECESSARILY KING
A cash deposit account might be the first port of call for many investors who want to generate an income. In an environment of low interest rates, however, it is difficult for savers to generate a meaningful return from their cash deposits. Furthermore, the impact of inflation will erode the purchasing power of their capital over the longer term.
Changes to UK base rates, which are set by the Bank of England’s Monetary Policy Committee, will affect the level of interest paid on cash in a bank deposit account but base rates will not affect the level of income paid on a bond. In an environment of rising interest rates, bonds become less attractive, because investors can more easily achieve a competitive rate of interest from their cash deposits. Similarly, low interest rates increase the appeal of bonds, as it becomes harder for savers to generate an attractive level of income from their cash deposits.
When bond prices fall, their yields rise and, when bond prices rise, their yields fall. However, the amount the investor receives – the coupon – is unaffected, so the investor receives the same amount of income, regardless of the movement of interest rates. Because fixed-income securities tend not to offer any real opportunity for capital growth, bond investors risk seeing the erosion of their investment’s real capital value in a climate of high or rising inflation.
As the name suggests, government bonds are issued and underwritten by a government. UK government bonds – also known as ‘gilts’ – are regarded as very low-risk investments as, to date, the UK has never defaulted on its debts. However, because they are a low-risk investment, the level of return available on gilts tends to be relatively low and they offer little protection against inflation. Index-linked bonds are the only exception – they pay a rate of income that is partly influenced by the rate of inflation. If the rate of inflation rises, the level of income they offer is adjusted upwards while, in an environment of falling inflation, the level of income paid will fall.
Corporate bonds are issued by individual companies as a way of raising capital for their businesses. As with gilts, a corporate bond is redeemed at a predetermined date for a fixed sum and, during the life of the bond, the investor receives a fixed amount of interest.
Corporate bonds carry a higher level of risk than UK government bonds but that level will vary from one company to the next. High-quality companies are regarded as relatively low-risk, whereas lower-quality companies are believed to have a higher risk of defaulting on their obligations to bondholders. The level of income paid to bondholders tends to reflect the level of risk involved. Investors who take on a riskier investment are compensated for that risk with a higher level of income.
If a company should go bust, bondholders rank higher than shareholders as the company has to meet all its obligation to its creditors – including bondholders – before it considers its shareholders. It is important to understand the risks of investing in corporate bonds. There can be a substantial difference in quality between one corporate bond and the next.
Many of the large fund management houses undertake research to evaluate the potential risk of each bond, but they also often rely on research produced by credit-rating agencies such as Standard & Poor’s, Moody’s and Fitch. These companies assign a rating to companies that offer bonds. A high credit rating indicates the company is believed to have a low risk of default while a lower credit rating suggests the company presents a higher risk of default.
Bonds may be divided into two classes – ‘investment-grade’ for the highest credit ratings and ‘sub-investment-grade’ (also known as ‘high yield’ or sometimes ‘junk’) for the lower grades. A lower credit rating means a higher level of income paid, in order to compensate for the extra risk involved. Generally, investment-grade bonds are seen as a relatively lower-risk asset class, while higher-yielding sub-investment-grade bonds are regarded as higher risk.
COLLECTIVE BOND FUNDS
Collective funds that focus on government and/or corporate bonds will invest in a managed portfolio that can help you to reduce your risk by diversifying across a range of investments, rather than owning just one or two. Some funds will focus on a specific area of the market while ‘strategic’ bond funds are ‘go-anywhere’ portfolios, whose managers take a view on the bond market and focus on the areas they believe offer most value. If you are interested in adding an element of additional risk to your overall portfolio, therefore, strategic bond funds can offer an introduction to the sub-investment-grade arena or to overseas opportunities.
INVESTING IN BONDS SUMMARY
In next months instalment of Investing for Income we will take a look at the income opportunities from investing in equity based investments.