Playing the investing for income game
For anyone looking to generate a decent level of income from their investments, these are challenging times, with rock-bottom interest rates meaning the returns on offer from banks and building societies typically fail to keep up with inflation.
So the big question is what savings and investment products are available that will produce the level of income you need - whether that's for immediate use as a supplement to your salary or pension for holidays and luxuries, or to reinvest and boost the value of your investment portfolio with the longer term in mind.
Your first port of call should be cash. Banks and building societies are offering very low interest rates but it's still worth holding some money in a cash ISA (up to £5,640 is allowed in the 2012/13 tax year), because even though returns will be low, they will be free of income and capital gains tax.
The alternative is to use a taxable savings account. Again, these are not paying much, and you will be taxed on interest earned, making it even harder to generate an inflation-beating income - particularly for higher-rate taxpayers. However, most people like to hold some cash to meet unexpected expenses.
A popular source of income is a bond. With these, you are effectively lending money to the issuer in exchange for a fixed rate of interest over a set period, with your original investment returned on a specified future date.
Although they can theoretically be issued by anyone, the most commonly used bonds are those offered by national governments - known as gilts when they're issued by the UK government - and public companies when they are attempting to raise money.
These investments can provide a strong degree of capital security and pay a steady income to investors. It's also possible to obtain relatively high levels of income if you tap into high-yield bonds or some overseas fixed-interest holdings. However, there's absolutely no guarantee your investment will be repaid in full, as the company issuing the bond may end up going bust or encounter problems in meeting its interest payments.
To help you form a judgement about a company's prospects, specialist credit agencies such as Standard & Poor's look at each one and award a rating based on their assessment of its ability to pay back the sum borrowed.
The most trusted are given a triple A (written as AAA) ranking, then it goes down on a sliding scale through AA, A and BBB. Anything rated BBB or above is classed as investment grade; bonds with a rating below BBB are known as high yield or junk bonds. Typically, however, private investors access bond markets through a bond fund, rather than individual bond holdings.
Investing in shares
You can also generate an income by buying shares in companies that pay dividends to their investors. As dividends are distributed as a fixed amount per share, shareholders receive a dividend in proportion to the size of their shareholding. The payment of a dividend can be viewed as a statement of confidence by the management team about the future prospects of the business. High-quality dividend-paying companies are also likely to deliver capital growth over time.
It can be tempting to buy companies that have the highest yield - defined as the dividend paid expressed as a percentage of the company's share price - especially as a number of companies are yielding more than 5% at the moment.
However, this can be dangerous as it may mean the share price has fallen because the company is in trouble, or that it's paying a high dividend that it cannot sustain. You will have to look at the company in more detail in order to get a clearer picture. Also, examine the dividend payment history to see what it has paid out to investors in the past.
Companies perceived to be the most likely to pay and increase dividends over the years are those with decent levels of free cash flow - which is effectively the amount of money they have at their disposal after paying all the various costs associated with their business activities.
In many cases these will be the big so-called blue-chip corporate giants that have traditionally operated in areas such as tobacco, oil and pharmaceuticals. However, it is increasingly possible to enjoy healthy dividends from smaller companies. It all comes down to research.
However, there are big risks attached to investing in individual shares. Apart from the costs involved, you need a substantial amount of money to be able to buy enough shares to achieve much diversification, and you then need the time to monitor them. Pinning all your hopes on a handful of shares also leaves you vulnerable to any problems those companies may encounter.
A safer, cheaper alternative to individual shares or bonds is an investment fund - either a unit trust/open ended investment company (OEIC) or an investment trust. For most people, a fund is the most sensible option, as the managers will be making key decisions based on their knowledge and expertise, and monitoring them regularly.
For unit trusts and OEICs, equity income investors should look primarily at the IMA UK Equity Income and Global Equity Income sectors. It can, of course, be tempting to stick with funds focused on UK companies but this may end up being rather short-sighted as you'll be overlooking potentially attractive sources of income from around the world.
Moreover, a criticism levelled at many established larger UK Equity Income funds over the past few years has been their reliance on a relative handful of companies and sectors with a longstanding record of paying substantial dividends, including financials and utilities. But a number of these areas came badly unstuck during the global credit crunch - especially banks, which struggled and in many cases suspended dividend payments. Other prominent dividend payers, such as oil giant BP, have also suffered problems that have affected the levels of income being paid to shareholders.
Buying into equity income funds means the manager makes all buying and selling decisions in order to generate an income; you can either receive payouts or have them reinvested for better longer-term gains.
You can also opt for a fixed-interest fund holding a portfolio of bonds. Depending on how much risk you're prepared to take and how much flexibility you want the manager to have, you could look at the IMA Sterling Corporate Bond, Strategic Bond, High Yield Bond or Global Bond sectors.
Investment trusts are structured rather differently from unit trusts. They are quoted companies in which you buy shares. The price of the shares is determined by supply and demand, rather than the value of the underlying assets in the trust portfolio. This "double-layered" structure means the value of an investment trust may be more volatile than that of a comparable unit trust (which directly reflects the value of the underlying investments). However, investment trust charges are usually lower.
One advantage with investment trusts is that they can retain up to 15% of the income they receive each year and put it into their reserves to pay out in more difficult years when companies may struggle to maintain dividend payments. This process is known as "smoothing", and can mean a more consistent income for trust investors.
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.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
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%.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
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).
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.
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.
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.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.