The hunger games

Last Updated on : 2nd November 2016

untitled Oscar Wilde observed that “it is better to have a permanent income than to be fascinating”. Well maybe? But the question of income and where to find it has become an increasingly frustrating exercise for many investors, whether it is for funding school fees, university costs or further down the road, retirement. People are talking about the “destruction of yield”. Which means what? “Yield is effectively the income return on an investment, such as the interest or dividends received from holding a particular security….and is usually expressed as an annual percentage rate based on the investment’s cost, current market value or face value.” What we are seeing is a phenomenon where the “income return” or yield on the traditional asset classes of cash and gilts (UK government debt) is being suppressed to a point where in real or “inflation adjusted” terms investors are experiencing historically low returns. It is worth thinking about that. UK inflation is predicted to be ticking up primarily as a consequence of the recent fall in sterling. At the end of the day this means your income buys less as prices rise and therefore has to “sweat” that much harder!

piggy-bank-1 So what is going on? Playing a crucial part in this outcome has been the continuation of the Bank of England’s QE or “quantative easing” programme. We have seen the UK interest base rate, post the Brexit vote in June, cut to a new historic low of 0.25% and projected to fall further in 2017 to 0.10%. Effectively cash has become a zero return asset class. The 10 year government gilt yield is at the time of writing hovering around 1%. Putting these numbers into some context, 10 year gilts in June 2006 yielded 4.6% and the UK base rate was set at 4.5%. We have therefore seen a dramatic reduction in the opportunity to build an attractive and sustainable level of income using a combination of cash and UK government debt. One concerning consequence of this radical and marked shift in the investment landscape is that investors have started to look more seriously at asset classes that traditionally have brought with them more “risk” and price volatility such as equities, property, and higher yielding government and corporate bonds. It is not surprising that some investors look more closely at the yield obtainable from equities when we see the FTSE-100 yielding around 3.84%. But investors need to be careful. Firstly, remember the dividend yield is a backwards looking measure, comparing a company’s current share price to the dividends they paid over the last year. Secondly, as share prices can rise equally they can fall, which has the consequence of artificially boosting the dividend yield. Also any dividend cuts are not immediately reflected in the dividend yield calculation.

My point is simple. The challenge around building a sustainable level of “income” has become more pronounced. Without seeking the right advice it can be very easy to make bad decisions as investor behaviour is skewed towards asset classes that are more volatile and potentially more dangerous to the value of your capital. There are solutions that in combination can work effectively but caveat emptor and if in doubt seek out some impartial and objective advice.

By David Lane, Partner and Technical Director LGT Vestra