EquitiesSep 25 2013

Seeking a clear path to safety

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It was four years in March since UK interest rates hit their record low of 0.5 per cent, where they have remained ever since.

Consequently, investor appetite for all things income has increased dramatically over the last 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 finally to 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 that are taking place before our eyes. Yes, the retirement age may slowly creep up; nevertheless the fact remains that the current generation will be retired considerably longer than previous generations, and it is for this reason that attitudes to investing in retirement need to change.

The textbooks tell us that 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. The problem with this view is that the ‘less risky’ asset is no longer less risky.

Let’s start 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 now obsessed with volatility and surely one of the most volatile assets from an income perspective is cash? Before the financial crisis in September 2008, the UK base rate stood at 5 per cent. All things being equal, this provided an annual income of around £5000 on a £100,000 investment. Today the return on that same investment has collapsed to £500. Now, if that is not a crash, I do not know what is. The point I am trying to make is that, if your requirement is income, investing in cash is one of the most volatile ways of achieving this and, in the current climate, probably unsuitable for most investors.

Aside from cash, income investors have traditionally looked to the fixed-income markets to produce an income. However, the problem with this 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, although, 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 per cent annual inflation (which is the Bank of England target) over 15 years, let alone the rate we have seen over the last few years? The results are quite frightening. So, sell your equities to buy gilts? Looking at the current yield on the UK stock market compared with gilts, that would be the same as accepting a 50 per cent reduction in pay and then freezing it for the rest of your life.

So, this leads me nicely to what I see as one of the best asset classes for income: our friend the equity. Shares have more than proved themselves over the years as an asset that is suitable for investors who require income. The capital value will be volatile, but for income-seeking investors, the volatility and reliability of the income stream (as well as the ability to grow the income) is much more important, and one reason why many commentators are currently focusing on the so-called ‘great rotation’ from bonds to equities.

While the jury remains out as to whether we are witnessing this great rotation, there can be no doubt that equities have the upper hand so far this year. Certainly, retail sales figures from both sides of the Atlantic suggest that investors have been far keener on equities over the last few months, and it is encouraging that markets have responded accordingly, with many developed world stock markets enjoying their strongest gains in January for many years. However, the more important question is, can the rally continue?

My view is that equities should provide decent real returns over the medium to long term. Valuations are certainly not too stretched and corporate balance sheets remain in good shape. Meanwhile – and this is perhaps understated – the amount of equity out there continues to shrink through a combination of mergers and acquisitions activity, particularly in areas such as UK small caps. Meanwhile, many larger companies have continued to take advantage of investors’ seemingly insatiable appetite for income by issuing debt at record-low levels while it seems like just good use of the balance sheet – although we accept that this strategy will not work ad infinitum and companies will eventually have to think of other ways of deploying their cash.

So in summary, we need to dismiss the rather one-size-fits-all style of investing that has crept into our industry over the last few years. The strategy for someone looking to accumulate capital – whatever their age, attitude to risk or time frame – 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.

Of course, biased as I am, you could look at a multi-asset solution where it is possible to achieve a far higher income than both equities and gilts from multiple sources. The best route to safety, is after all, to diversify, and this of course applies whether your investment goals are either to produce an income or accumulate.

David Hambidge is director of multi-asset funds at Premier

Key points

- Investor appetite for all things income has increased dramatically over the last 12 months or so.

- Aside from cash, income investors have traditionally looked to the fixed-income markets to produce an income.

- Equities should provide decent real returns over the medium to long term.