The past decade of record-low interest rates has had a huge effect on anybody who needs to earn a robust income from their capital. In essence, they have been forced to change from savers (who earn income from bank deposits, protected by government guarantees) to investors (who don’t enjoy that safety net and need to think more about the risks they take).
This is unlikely to change. Optimists point to rising interest rates in the US and suggest that this world of low rates is almost at an end – which would help savers. Yet the Federal Reserve will be lucky to get away with another 1% to 1.5% of interest-rate increases before it runs into the next recession, topping out at interest rates of 2.5%. And the Bank of England is starting from an even lower level, making a rapid rise even harder. So while slightly higher rates might be in the offing, we can’t expect a return to the long-term normal of around 5%.
Still, rising rates should prompt investors to think more closely about the hierarchy of income returns and risks that come from different types of investments.
In very simple terms, what I call the “ladder of income yields” goes like this:
• Yields of 1.5% to 2% are still just possible from relatively risk-free options. These include government bonds and high-interest deposit accounts.
• Returns of 3% or more usually involves investing in a bond fund. These will contain a mixture of bonds from low- and high-risk corporate issuers with yields varying between 1% and 5%. A few years ago, the typical yield would have been closer to 4%, but in recent years the average has started to slip below 3%.
• At the 4% level, we’re into riskier terrain, but there are plenty of options. Many equities offer dividend yields in this band.
• A yield of 5% is probably the level where many of us want to end up. It’s close to the long-term average for interest rates and is also very roughly equivalent to the annuity rates on offer for older savers and investors.
• Investors who are willing to embrace alternative assets can achieve 6% or so, but the level of risk to achieve this is starting to increase substantially.
• By the time you get to 7% or more, you’re beginning to get into very risky territory, although there are pockets of value if you’re willing to invest in funds whose capital value may be volatile.
• Anything above 8% in income terms is widely viewed as too risky for mainstream, while 10% or above is tantamount to investment suicide. Avoid!
If you are willing to take sensible risks then the chances of boosting your income yield above the 2% to 3.5% level are vastly increased. In my view, it should be possible to get an average of around 4.5% per year on a balanced portfolio of ten mainstream investments and 5.5% on a more adventurous portfolio. So over the next few months I will be introducing a series of income investments in these pages that fit into two model portfolios (see below for details).
Some of these recommendations may be familiar to you, some may not. They will mostly not be risk-free: investors have to accept that there might be a short-term move up or down in the price or market value of an investment. More significantly, some of the capital invested might be at risk (as well as the level of income), unlike a bank deposit. Still, I believe that they should collectively produce a robust, well-backed stream of income that might even rise over time.
Principles of income investing
My model portfolios will be based on some key investment principles. Diversification is perhaps the most crucial of these. You need to make sure that you don’t have too much of your money in assets that are vulnerable to the same events. For example, don’t have everything in bonds that could be hurt by a sharp interest-rate rise (even if this is unlikely). Split your bond holdings between sovereign (government) and corporate borrowers, which carry different risks. Diversify internationally (but remember that most income investors don’t want to worry about sudden changes in the exchange rate for sterling, so look for international assets that pay sterling dividends).
Also be aware of liquidity. Many of the adventurous investments are less liquid, meaning that if you want to sell them in a panic, you may get a poor price (or not be able to do so). Illiquid assets often offer higher returns, if you are willing to think long term, but you need to keep enough of your portfolio in more liquid investments (cash or very short-term government bonds).
How I build my portfolios
My plans for a balanced portfolio aim to deliver a yield of 4.5% with underlying investments yielding in a range of 3.5% to 5.5%. The portfolio features more mainstream investment ideas likely to appeal to the cautious investor. That means mostly unit trusts and exchange-traded funds (ETFs). Most of the underlying investments should be more liquid and easier to sell in a market panic. This portfolio may be more vulnerable to interest-rate risk as its underlying yield is lower and thus could be hit hard if rates rose.
Meanwhile, my adventurous portfolio will target a yield of 5.5%, with underlying investments yielding in a range of 4.5% to 6.5%. These will be less liquid and more likely to include complex investment trusts or direct corporate and retail bonds. These less liquid investments have higher bid/offer spreads requiring investors to think long term. The underlying investments are likely to be less vulnerable to the risk of rising rates, as they boast higher yields, but they are likely to be more volatile in price terms.