How to generate an income in a low-yield world
Jun 09, 2009
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One major aspect of the credit crisis and the frenzied attempts to deal with it that is being largely ignored by the media and policymakers is the collapse in the incomes of huge numbers of retirees and others who depend on interest earned on their savings.
Most bank deposits now pay little or nothing, and the rates on offer are being cut by the day. The yield on short-term government bonds is down to around 1% in the US and Germany, only half that in the UK and Switzerland, and almost nil in Japan.
The problem, of course, is that central banks are cutting their policy rates to zero, or have already done so.
Their focus is on saving their friends in the banking sector from wipe-out in the mistaken belief that giving life support to disease-ridden, incompetently-run financial leviathans is essential to ward off economic collapse. They have no interest in shielding the largely innocent public from the pain inflicted by falling rates.
Voter backlash will eventually bring common sense into play and force the authorities to direct support to where it is most needed and likely to be most effective – the well-managed enterprises best situated to create new jobs, and the banks that largely avoided the disgraceful orgy of speculation in credit.
One indication of the potential political power of those who save versus those who borrow is that in Britain there were at the end of 2007 fewer than ten million residential mortgage borrowers, but more than 140 million savings accounts. Of course, the average mortgage loan is far greater than the average savings balance – but the voters with savings are far more numerous.
On average, UK savers with money in an instant access account now earn just 0.17% on their deposits, while some earn as little as 0.01%.
In real terms, rates of interest on offer aren't quite so bad, as inflation has fallen to about zero. But ordinary folk don't think in inflation-adjusted terms. And making tiny drawings of capital to provide the cash needed for living expenses is a clumsy business compared to receiving distributed interest income.
A major problem when making any decision in the investment or financial sectors is that every one of us has an inherent bias towards favouring those with which we are familiar.
Nearly all central bankers have spent their lives working with and befriending other bankers. They cannot comprehend or accept that the crisis that began in sub-prime has made a nonsense of what they've been doing for decades, wiping out most of the wealth apparently created.
Zero-interest policy is ineffective
They believe the mega-banks have to be saved by mind-blowing quantities of taxpayer and "printed" money, and "improved" regulation – instead of facing up to the cost of the credit catastrophe and to the task of building a new, sound system on the basis of the good bits of the past that can be rescued and fostered.
Much of the benefit of the zero-interest policy is illusory. Banks that can borrow almost-free recycle the money back into government bonds to take advantage of the interest-rate difference. It's economically pointless circular activity, with reinvestment of the money in those bonds providing more money for governments to lend to the same banks.
This may misleadingly make their terrible balance sheets look a little better, but does nothing to underpin economic activity.
The banks aren't keen to lend to those who really need their money – for example, those who need working capital to keep their businesses operating.
Where does this leave investors who need income?
• Think in terms of total return – income plus capital gain, after tax.
Falling interest rates may produce reciprocal capital profits, as in the case of longer-dated traded bonds.
And they are usually associated with falling inflation. Lower inflation masks the pain of destruction of the purchasing power of income from rising prices; where it turns into deflation, purchasing power actually increases.
• It may be possible to offset the negative effect on cash flow of falling income from declining interest rates by making small, regular withdrawals of capital.
• Review your portfolio to see if you need to do any restructuring to bolster future income flows. For example, I recently switched some money earning virtually nothing in a bank account into purchase of shares in a company that I am confident will be able to sustain its relatively attractive dividend through the difficult times ahead.
Unfortunately you need to make some currency assumptions when considering such switches, as exchange-rate fluctuations could have a greater impact on your flows than changes in the capital values or income payment rates of investments.
By sticking to the currency you need to meet all or most of your spending alleviates exchange-rate risk, but has some less-apparent downsides. It also abandons the opportunity to boost both income and capital value from the appreciation of being in the right currency other than your own, and may reduce the level of your protection against inflation in your home country.
For income-seeking investors, bonds are currently a particularly difficult sector to judge.
Many eminent analysts argue, with good reason, that current low yields on the safest longer-dated bonds, both governments and corporates, cannot be sustained. Capital values are likely to be devastated by the twin effects of an avalanche of new paper by governments seeking to finance their crisis-bloated fiscal deficits, and eventually by an explosion in inflation caused by all the money being created.
However the fairly stable, low level of yields on longdated governments suggests that the markets don't see that as an immediate problem; the belief that we are heading into deflation, which will add purchasing power to low nominal incomes, leaving investors better off in real (inflation/deflation-adjusted) terms.
The contrary view is that yields will stay low for as long as investors prefer the safety of state-guaranteed debt and central banks remain willing to "print" the money to buy government bonds. Inflation can only come with global economic recovery, which is going to be slow coming, and sluggish.
Protection against inflation risk
However, we could face stagnation – rising inflation without any improvement in economic activity.
The most obvious investment for those who must have some income but want protection against inflation risk is indexed bonds. But they only offer income yields about as poor as bank deposits. And in any case, their supposed protection against inflation is partly fictitious, as it is based on changes in official indexes of retail prices that are manipulated to make inflation appear lower than it really is.
I think conventional bonds are more attractive, as they offer substantially higher income yields, such as around 4% to 5% on long-dated British/German/French/Dutch governments.
It's a common illusion to think that if you own such bonds, only repayable in 20 or 30 years, that you're locked in till maturity date and face huge risk from future inflation. In fact, if you keep an eye on what's happening and see that the markets are starting to anticipate the return of inflation, you can quickly sell such bonds.
One of the few advantages private individuals have over institutional investors is that they usually don't have to worry about the liquidity of the markets in which they trade because the volumes in which they deal are so small.
Of course, reverting into cash would mean loss of income. But it's fallacious to argue that low-yielding cash deposits must be bad investments. Providing they are with safe banks, such as those guaranteed by governments, you avoid the risk of capital loss in fluctuating securities.
Corporate bonds are the flavour of the month because of the high yields they offer, and there is certainly a case for them. However, the high yields reflect the market's view that default rates are going to be very high, perhaps as high or even higher than those experienced in the 30s.
The outlook for dividends
Do you really want to accept such risk to secure a better income? Maybe… if you are very selective, and pick securities or bond funds such as ETFs that you can easily exit if you see warning signals.
Equity income is similar in concept, but has yet to attract as much investment attention. I explained recently why they could be a better choice than bonds. Dividend yields are relatively high as a reflection of the risk that so many major companies are likely to cut or even stop paying dividends in the rapidly worsening global business climate.
However, if the experience of the Great Depression is any guide, dividends are likely to fall less than earnings or share values as managements strain to underpin their shareholders' morale. In the US, dividends fell 47%, peak-to-trough, compared to 67% for earnings, 81% for the S&P Composite index (all in real terms).
Derivatives markets suggest that institutional investors expect dividends paid by Britain's 100 biggest companies to halve by the end of next year.
As with corporate bonds, there is a case for seeking out those shares where the yields, much higher than cash at the bank or government bonds, are well-covered and seem sustainable.
They are likely to be those of very large groups with low levels of debt, strong competitive positions and good international diversification, in sectors where demand is not likely to fall sharply, or indeed may continue to grow, such as energy, pharmaceuticals, tobacco, healthcare and many other service industries.
You may consider equity income funds such as Aberdeen Asian Income. Asian companies' dividends are generally less threatened than those in other regions because of low debt levels – they learned their lesson in their earlier Asian crisis of 1997-98.
This London-listed investment trust currently offers a dividend yield of about 4.3%, and you might be able to get as much as 5% if you can pick them up at a lower price in a market correction.
Some advisers whom I respect are promoting structured products that generate income flows. However personally I have never favoured, nor invested in, investments based on derivatives. They involve all kinds of risks, such as counter-party risk, that may seem too remote to worry about – but have a way of erupting without warning.
Some investments in my family's portfolios offer regular cash flows that contain capital repayment elements, but are like stable incomes, such as annuities, South African flexible retirement funds, and UK insurance funds that allow annual withdrawals of 5% of (tax-free) capital.
Another possibility is gold. If you had invested $100,000 in bullion coins ten years ago, selling off 5% at the end of each year to provide you with cash, by now you would have gold worth more than $200,000. In the meantime, you would have enjoyed an income – usually tax-free – totalling more than $71,000.
In the new world of global investment and finance that we have entered, will income rates be permanently lower than we've been used to, because depression suppresses demand for credit; or will they be permanently higher because lower corporate profits, fiscal deficits and generally tighter family finances leave less cash to spare?
I don't know. But you need to think a lot about such things if you have retired or expect to do so within the next couple of decades.
• This article was written by Martin Spring in On Target, a private newsletter on investment and global strategy. Email
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