Choosing which investments will create the best return has always been a challenge. The last ten years have made it more difficult as record low interest rates have rendered some options, particularly those in cash, effectively pointless.While some are predicting that these rates may rise in 2017, it is unlikely to be by a significant amount as consumer debt remains high and the effect on the mortgage market would be damaging. However, what we are seeing at the moment is inflation return.
In October 2015, inflation had fallen to 0.2%. In just over two years, in February 2017, the rate had risen to 2.3%. In April 2017, it reached 2.7%, the highest level in over three years.
The government’s target for inflation is 2%, so this 2.7% rate is by no means alarming. However, the rate of growth has been steep and it is likely that it will continue to grow this year, creating a challenge for investors as they try to protect the value of their returns.
Henderson Managed Investment Trust’s research team analysed twenty years of data on income from bonds, shares and savings. The team assumed the income was taken and spent each year, not reinvested - this is a typical behavior for an income investor.
The research shows that increased inflation poses a risk to savers holding money in cash accounts, which could see the real value of their capital fall. Savings in cash have paid an average £138 per year on £10,000 since 1997. However, they are now returning just £22.
It’s a similar story for government bonds that were bought to mature after 20 years in 1997. These would have yielded investors a return of around 7.5% whereas a 20 year bond bought today will lock money into a low return of 1.4%.
By contrast, £10,000 of equities (shares) bought at the end of 1996 will yield £704 in 2017. This means that equity yields can provide a real income. The added benefit is that as both company profits and the economy grow, so do dividends (payments companies make to shareholders if the business has performed well), whereas bond interest does not. As such, equity income is somewhat protected from inflation and represents a genuine growth opportunity as business revenue and earnings should increase at around same pace as inflation, which means that the prices of shares should rise along with the general prices of consumer and producer goods.
Equity income grows in most years, so an investor in equities in any given year will expect his income to be sequentially larger in future years. This is why, for example, a 1995 investor in equities has an average income of £596 - £402 in 1995 rising to £946 by 2017.
Of course, investors’ capital is at risk if they choose to put their money into equities, whereas the nominal value of their savings is guaranteed with government bonds. However, in real terms, the ravages of inflation always take their toll.
Click on the table to enlarge.
Source: Henderson Managed Investment Trusts, May 2017. Data on bond and equity yields (returns) sourced from Bloomberg, and savings interest rates from the Bank of England. Inflation data was sourced from the Office for National Statistics (ONS), while other data came from the Debt Management Office.
- James Henderson is fund manager of Lowland Investment Company, a UK equity income investment trust.