The Quest for Income

Since March 2009, the Bank of England has anchored the minimum Lending (or “Base”) Rate at just 0.5%, which is unprecedented in two ways. Firstly, it is first time in 300 years that the Base Rate has been set at such an ultra-low level. Secondly, it is highly unusual for Base Rates to stay at the same level for such an extended period. Furthermore, the Base Rate is set to stay where it is for some time to come.

Aside from the historic perspective, the knock-on effect on cash deposit interest rates has dealt a vicious blow to anyone who relies on income from savings to supplement other income, such as Pensions. In a double whammy, Retail Price Inflation nudged past 5% last month, meaning that the real value of savings is being eroded. The average branch based instant access account now pays less than 1% per annum gross interest, and whilst this rate can be improved upon by using internet or phone accounts, you will be hard pressed to find any instant access account that pays more than 3% per annum. Indeed, due to the fact that Banks and Building Societies have had to pay more to borrow money over recent weeks (as a result of the Eurozone debt crisis) deposit interest rates have been steadily falling even further since the Summer.

But what can investors do to increase their income? Firstly, using Cash Individual Savings Accounts (or ISAs) will increase the income stream for basic and higher rate taxpayers, as then interest will be paid without deduction of income tax at source (non taxpayers will see no advantage as they should not pay any income tax on their savings in any event). But Cash ISA rates are little better than ordinary deposit rates, and the annual allowance limit, currently £5,340 in the 2011-12 Tax Year, is restrictive

Beyond the Cash ISA, for all but the most risk averse of investors, there remains value in Fixed Interest Securities as a way of achieving an improved income stream from a capital sum. Fixed Interest securities are debt issued by either Governments or Companies as a way of them raising finance through the markets. They come in many different guises, but the most common for domestic investors are Corporate Bonds (debt issued by Companies) and Gilts (debt issued by the UK Government).  Fixed Interest Securities (as the name suggests) tend to pay a fixed income for a fixed period, when the issue is redeemed at a pre-determined price (usually 100p), subject to the financial ability of the company to repay. In the unusual event that a Bond issuer cannot repay, this is known as a “default”, which could lead to a percentage loss on the capital value (colloquially known as a “haircut”). In the event of a default occurring, Bond holders rank ahead of ordinary shareholders in the queue to receive their capital.

There is a wide range of Corporate Bonds in circulation, issued by a vast array of different companies. Lending money to the most financially secure will tend to yield a lower income than lending to a less secure company. This is the trade-off between risk and reward, as investors in lower graded debt, with a higher chance of default, demand a higher rate of interest to compensate for the risk.

Despite the economic conditions, default rates remain at very low levels, particularly in the higher graded Bonds. According to research carried out by M&G, default rates on investment grade debt (i.e. BBB+ or better) stands at between 1% and 3%, and Higher yielding debt (i.e. BB) at 9.6%. Default rates can be minimised further by investing in a collective investment, which holds a range of Bond investments, so as to obtain an adequate spread and diversification across a range of issuers.

At the lower end of the risk scale, UK Gilts (issued by the UK Government) yield between 2% and 3% gross per annum. Slightly more risky than Gilts, Investment Grade Corporate Bonds (i.e. those rated BBB+ or better) yield between 4% and 5% gross per annum (and in my opinion represent the “sweet spot” at present between risk and reward). Higher Yield issues yield 6% gross per annum or better. These compare favourably to cash interest rates at present, but it is important to bear in mind the default risk; in addition, a further risk inherent with fixed interest investments is that they tend to become less attractive in periods when interest rates rise rapidly. However, in the current climate, this appears a remote possibility – our current estimate is for the Base Rate to stay on hold until the end of 2012 - but in the longer term, this factor should be borne in mind.

Corporate Bond prices did suffer a little during the late Summer market malaise, but have begun to rebound over the last few weeks. They remain an attractive investment proposition in the medium term, and certainly give an option to boost income in this unusual period when cash returns are so unattractive.

As ever, before committing to any investment strategy, you should seek impartial advice from a qualified investment professional, and any decision should take into account your personal circumstances and tolerance to risk.