From Special Report: Search for Income - February 2013
Alternatives to cash for safe income generation
Keeping money in cash very unappealing, not least because of the very low rates of interest on offer.
We find ourselves in perverse times. Base rates in the UK remain rooted at record low levels, with no sign of a change in stance from the Bank of England. This creates significant problems for those who wish to earn an income on their capital.
First, it makes keeping money in cash very unappealing, not least because of the very low rates of interest on offer. Second, with inflation remaining stubbornly above the Bank of England’s target and significantly above the base rate, the real value of cash is being eroded by around 2 per cent a year – all this from a supposedly risk free asset. Indeed, you would have to go back to the 1970s and 1980s to find such a corrosive environment for holding cash. Finally, and more subtly, a huge variety of asset classes are priced with reference to cash rates, resulting in lower-than-expected returns from almost any asset class you can care to think of.
So where should those who want to generate income turn? The obvious first port of call would be fixed income securities, particularly if investors are divesting out of cash and investing for the first time. Fixed income, as the name implies, offers investors a fixed return from a bond. For some bonds, such as those issued by AAA-rated governments, there is virtually no credit risk. However, the recent downgrading of several sovereigns has reduced the number of top-quality debtors and demonstrated how quickly even sovereign ratings can change.
The drawback of these ultra-safe bonds – which includes those issued by the US, UK and Germany – is that they offer the lowest yields, which may not be enough to meet investors’ income needs. Furthermore, in many places, such as the UK, the yields on offer are often negative when the effect of inflation is factored in. To receive higher yields from fixed income, investors need to invest in bonds that entail greater credit risk. Theoretically, this should increase income and total returns in the long run, but it also increases investors’ risk of losing part of their initial investment. The events of 2008 showed how a concentration in credit can materially impact a portfolio in a crisis. Nonetheless, investors have piled into fixed income over the last few years, with the riskier parts of the market benefiting the most in the so-called ‘stretch for yield’.
Investors can usually also achieve extra income by buying longer-dated bonds, that is, those with more years to maturity. For example, the 10-year UK government bond currently yields around 2 per cent while the 30-year bond yields slightly above 3.2 per cent. However, longer-dated bonds also come with higher duration, which means they fall more in value if yields rise. This is a particularly relevant consideration given that yields are already trading close to record lows, having been falling for approximately 30 years. Moreover, the low level of coupons offers less protection to bond investors’ total returns, and when interest rates normalise, they are likely to be faced with significant capital losses, particularly in longer-dated bonds. This means that anyone investing now expecting to achieve similar levels of return as they have historically is likely to be sorely disappointed.