In an economy of balance sheet deleveraging and low growth a key challenge for investors is the search for income. The impact of the financial crisis in 2008 has led to structural changes in the UK economy with very low interest rates having become the norm. By low interest rates we need to distinguish between those that apply to cash and those that affect UK government bonds i.e. gilts. Often the two are confused. For example Coalition politicians defending the austerity cuts often argue that we have to maintain this economic policy and protect our AAA credit rating in order to ensure mortgage rates remain low. I think there is a bit of spin here. The point is that the UK’s economic credibility impacts on gilt yields and hence the government’s future borrowing costs not mortgage rates. The latter are determined primarily by the Bank of England base rate not gilt yields.
The scenario of low interest rates is unlikely to change in the near future as they are required to stimulate economic growth and reduce unemployment. In this sense central banks have shifted from their traditional remit of inflation targeting. Evidence of this is in the UK where inflation has been well above its 2% CPI* target for a long time yet the Bank of England has kept its base rate at 0.5% p.a. for over three years now. Ordinarily interest rate rises are used to reduce inflation but this monetary policy has been kept under firmly under wraps.
In the current environment low interest rates on cash means this asset class is a very poor investment for income seekers and capital is eroded in real terms by inflation. For those coming up to retirement and buying lifetime incomes from pensions there is a double whammy, low interest rates on gilts, supported by QE** has hammered annuity rates which are priced off of gilts. For those lucky enough to have secured retirement income from generous index linked final salary schemes or who bought annuities in the past when rates were higher you may be in a better financial position than new retirees but you will have seen your annual pension increases trailing inflation busting price rises in food, utilities and petrol in recent years. The “grey” inflation rate focused on life’s essentials not i-pads, flat screen TVs and 3G phones is typically higher than average.
So where do investors find income? In a recent article from M&G they highlighted the importance of high yield corporate bonds. Yields vary but may be as high as 8%-11% from relatively good companies. High yield, as it says on the tin offer real rates of return over and above inflation. M&G also point out high yield bonds have outperformed equities since December 1997 and with low volatility. I must stress the comparison was with equity indices such as the FTSE All Share and the S&P 500 rather than actively managed equity portfolios.
Another attractive feature of high yield corporate bonds is that they are much less interest rate sensitive than gilts or investment grade bonds. An interest rate shock, for example a reversal of the BoE monetary policy could send gilts into a tail spin with capital values falling sharply. The return from high yield is more determined by credit risk of the issuing company rather than interest rates. Finally high yield corporates bonds as with other forms of fixed interest are especially tax efficient when held within an ISA. This is because the plan manager can reclaim the 20% tax in interest. In contrast the 10% tax credit on dividends from equities is not reclaimable.
The choice of fund manager is crucial when it comes to selecting a bond fund. Aside from being a firm believer in active fund management rather than passive index tracking M&G made an interesting point. They compared spread dispersions for different categories of credit ratings in June 2007, before the financial crisis and at the end of 2011 and found they had become much greater. To explain. A spread is the excess return of a corporate bond over and above an equivalent gilt. For example if a gilt yields 2% and a corporate 6% the spread is 4% p.a. It is the extra yield the market demands for the additional risk of buying company credit as opposed to a “risk free” gilt. Further most corporate bonds have their credit ratings assessed and typically these are AAA, AA, A and BBB for investment grade and BB, B, CCC, CC etc. for non investment grade. Typically the lower down the credit scale you go the higher the yield. However within each credit category e.g. BB- or CCC+ the spreads vary much more now than they did in June 2007. This means that there are large differentials of value in high yield and a good fund manager is recommended to seek out these stock selection opportunities.
Finally for the sake of balance I must point out high yield bonds are not the same as cash and capital values can fall. They also carry default risk although pooled investments reduce the impact. In addition high income can also be provided from structured products and equities.
* CPI – Consumer Prices Index ** QE – Quantitative Easing