Playing the investing for income game
Many of us have come to rely on the income generated by our savings – not only to pay for little luxuries, such as foreign holidays and flat screen televisions, but also to help cover the monthly bills.
This 'extra' money can be a tremendous boost to our finances at any age, but is particularly important when we give up work and need to supplement our pensions.
However, plunging interest rates – which sunk to their lowest level in more than 300 years at the back end of 2008 – have made it increasingly difficult to earn decent levels of income from traditional savings accounts.
So the question is: how else can you generate income from your hard-earned cash? Should you consider investing and, if so, what are the risks involved?
Geoff Penrice, a financial adviser at Honister Partners, believes it all depends on how long you want to tie your money up, because those who are able to invest for the longer term can benefit from a much wider range of options.
"Short-term investors who want to retain access to their money should remain in cash," Penrice advises. "Even though returns are low, the capital will be secure, and that will be important for people who don't want to put any of their money at risk."
If this is the case for you, high street banks and building societies are an ideal starting point. Savings accounts are generally straightforward to open and simple to understand, and you can deposit money quickly and easily.
The downside, however, is that the income generated depends on prevailing interest rates, which are subject to change, and this makes long-term planning tricky.
Find the latest top savings accounts
Kevin Mountford, head of banking and credit cards at moneysupermarket.com, says you can currently get around 3% in easy-access accounts, while up to 3.3% is available for those willing to lock their cash away in a notice account.
If you haven't used your cash individual savings allowance, this should be your first port of call as all interest will be tax-free.
It always pays to shop around for the best deals, because the interest rates available from these products can vary enormously, as can the regularity with which they are paid. Some accounts may also offer complex terms and conditions, such as additional bonuses.
Andy Gadd, head of research at Lighthouse Group, says you need to ensure you know what interest rate you will receive. "Some headline rates are misleading, so you need to examine them in detail," he warns.
You also need to find out where you can make deposits and withdrawals, as some accounts offer branch-based services, while others only allow you to use telephone or internet banking services.
Restrictions may also apply, which govern how much has to be saved in the account to qualify for different rates of interest.
Notice periods for withdrawing your money without penalties are also likely to vary enormously. Some providers allow instant access, while others insist you tie your money up for 90 days or longer.
And if you rely on the income generated by deposit accounts, bear in mind that if you continually spend the interest you receive, then your capital will never increase. In fact, its value will actually fall over time, due to the negative effect of inflation.
If you're looking to yield a slightly higher income you need to move away from cash. For those of you who do not wish to take much of a risk, you could consider fixed-interest accounts – usually accessed through a specialist bond fund – which normally pay a better rate of interest than cash, in return for a bit more risk.
These products, usually known as bonds, mean you effectively loan money to a government or company in exchange for a fixed rate of interest over a predetermined period. The product's face value is returned on a specified future date.
Bonds issued by stable governments such as the UK are regarded as the safest, although the downside is that their low-risk status means they will usually offer a much lower rate of interest than higher-risk bonds.
In the UK, government bonds are known as 'gilts', and can either be obtained new through the government's UK Debt Management Office, or second-hand via the stockmarket. If you opt for the latter, you usually go through a stockbroker.
Adding to the complexity is the fact there are two main types of gilt – conventional and index-linked, although both are denoted by the interest paid (known as the 'coupon rate'), as well as the date on which it matures, for example '3% Treasury Gilt 2014'.
With conventional gilts, the government agrees to pay the holder a fixed cash payment – known as a 'coupon' – every six months until the maturity date, at which point the initial sum invested (also known as the 'principal') is returned.
Index-linked gilts, meanwhile, take inflation into account as they were issues, which means both the coupon and the principal will be adjusted in line with the UK retail prices index.
But if you feel gilts are not generating enough income, you could consider corporate bonds, which are slightly riskier but usually generate a higher yield.
These mean you lend money to companies in exchange for an agreed rate of interest and the face value of the bond back in the future.
Each bond will have a nominal value (usually £100), which is the price that will be paid to you when it reaches the end of its life, in addition to the bond's yield. Although life spans will vary, they are generally less than 10 years.
However, there's no guarantee that the issuing company will keep up with the interest payments – or pay the face value on the date of maturity. The likelihood of them honouring their commitments is analysed by specialist ratings agencies on a sliding scale.
The most trusted bonds will be awarded AAA status.
The amount of risk taken – and the potential return an investor might receive – increases the further you move down the ratings scale. Those rated BBB or above are known as 'investment grade', while those below are classed as 'high yield' – sometimes referred to as 'junk bonds'.
Holders of these bonds will be backing financially riskier companies in exchange for an increased level of potential income.
Equity and commercial property
If you're happy to take this level of risk, other asset classes you could also consider are equity and commercial property. On the equity side, you can buy into companies that are expected to pay a decent income to investors in the form of regular dividends – but this is not a strategy for the faint-hearted.
A more common option is to invest in an equity income fund, whereby you rely on the skills of a specialist fund manager to do the research on your behalf and purchase a portfolio of shares for you.
Unless you're comfortable purchasing and trading individual stocks yourself, then this will be the most sensible path for you.
Of course, even having your portfolio managed by a specialist is no guarantee of success. Stockmarkets can be volatile – as has been illustrated over the past 18 months – so you need to be sure about the kind of stocks the manager is buying.
The next area that may warrant a look is commercial property. While most people won't have the financial means to buy an office block or a string of warehouses, they can buy into specialist funds that do have this capability.
Although the sector has had a torrid time of late, the rent paid on the average UK commercial property, as a percentage of the current, significantly reduced property values, equates to a yield of around 8%. This may be attractive to income-seekers, although capital values could still fall further.
People looking for income should stick to property funds that are heavily invested in actual bricks and mortar rather than shares in property companies, as the latter will increase your exposure to the stockmarket.
It's also worth remembering investment trusts, adds Annabel Brodie-Smith, spokesperson for The Association of Investment Companies.
"The investment company sector has an enviable track record of dividend increases, and this is particularly relevant right now when interest rates are at an all-time low and yield is much harder to come by," she says.
An investment trust is basically a company listed on the stock exchange that buys and sells shares in other companies rather than producing specific products or services.
Guaranteed equity bonds
If none of these investment vehicles suit you, another alternative is guaranteed equity bonds which, broadly speaking, promise a stockmarket-linked return if the market rises and the return of your original investment if it falls.
However, there are different types of guaranteed equity bonds. Most of the deposit-based products from banks and National Savings & Investments will return your capital in full, but that's not the case with many other providers.
The so-called 'guarantee' that is often quoted, according to consumer advice from the Financial Services Authority, is usually followed by an 'if', which means it's only protected if a particular stockmarket index meets certain conditions.
Which option should i go for?
Alec Letchfield, deputy chief investment office at HSBC Global Asset Management, does not believe the outlook for UK gilts looks attractive, particularly because of the huge amount of debt issuance that has taken place in recent months.
"We like higher quality corporate bonds. Although they have enjoyed a very good performance and so volatility may be a bit higher, on a medium-term basis there is still quite a bit of value available," he says.
"We also like equities, as we believe the economy is recovering, valuations are fair, and earnings will come through."
Letchfield does not expect this to change soon. "Equities have done so well because people have not been able to get decent yields on their cash and have been looking elsewhere," he says.
"We expect interest rates to start rising at some point next year, but it will be from very low levels so it won't be dramatic."
Instead of restricting yourself to a particular income-generating asset, it might be an idea to hold a few within your overall investment portfolio, suggests Gadd.
"Equity income funds, commercial property, high-yield and emerging market debt, together with convertible bonds, all offer significant income opportunities for investors with longer-term investment horizons," he says.
"The best way of generating income is to combine these in a portfolio with a suitable risk profile."
Income-generating fund recommendations
Andy Gadd, head of research at Lighthouse Group, says: "M&G Strategic Corporate Bond Fund is a reasonably defensive bond investment. Manager Richard Woolnough's idea is that when it comes to investing in credit, the best performance is gained by avoiding the losers rather than picking the winners."
He also likes Artemis Income: "Manager Adrian Frost has a good track record and focuses on solid, dependable companies. The fund has the prospect of producing a rising income and capital growth over the medium to long term."
Geoff Penrice, an IFA at Honister Partners, recommends Invesco Perpetual Corporate Bond Fund: "This bond is offering a decent yield, and is run by two experienced managers, Paul Causer and Paul Read, who have been successful over a long period."
Mark Dampier, head of research at Hargreaves Lansdown, points to Invesco Perpetual Income: "Equity income has been out of favour in the rally because everyone has gone for capital growth, but I like the defensive shares in which manager Neil Woodford is investing."
Could low risk be high risk?
Caution pays, as the old saying goes, but it could also prove to be a costly long-term strategy.
The fact is that your investments need to be earning a return substantially higher than the rate of inflation, otherwise the value of your money will fall.
By their very nature, cautious investments – such as bonds – take extremely low levels of risk and are usually only capable of generating modest returns, so you will need at least some exposure to 'racier' assets like equities for your investments to grow.
The cumulative benefits of reinvesting income
You don't have to take out the income generated – in fact, you could make even more money over the longer term by reinvesting it into your chosen fund. For example, a £10,000 investment earning 5% would generate £500 in a year.
If you withdrew this income and the interest rate remained the same, you would still only have £10,000 capital and earn £500 in year two. However, if you reinvested that original £500 into the fund, you would earn £525 – an extra £25.
A savings account on which the account holder is required to give a period of notice before making a withdrawal or face a penalty, usually a loss of a specific number of days’ interest or pay a fee. Notice periods of 30, 60 or 90 days are common. These accounts usually pay higher than average interest rates and require large initial deposits (£1,000 minimum) so the notice period and penalties are there to discourage withdrawals. Some of these accounts will only allow a certain number of withdrawals a year.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A stockmarket security (a form of derivative) issued by companies on their own ordinary shares to raise capital. A warrant has a quoted price of its own that can be converted into a specific share at a predetermined price (called the conversion price) and future date. The value of the warrant is determined by the premium of the share price over the conversion price of the warrant. Warrants give the same economic exposure to an underlying security without actually owning it, and cost a fraction of the price of the underlying security.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.