Coping with falling investment yields

Coping with falling investment yields

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Now that the US election appears to be (at least largely) decided and given the recent news about potential coronavirus vaccines, in the last few weeks investors have been focused on equities. This is hardly surprising given that the index of the UK’s largest hundred companies has risen by nearly 15% since the end of October, while in the US the S&P 500 is up around 10%.

However, most investors do not hold a portfolio comprising solely equities. In most cases, they will hold a substantial part of the balance in fixed interest investments, also known as bonds. Whatever happens in equity markets however, it is unlikely that bond returns over the next 10 years will be as good as the last 10. At the end of 2010, yields on 15 year UK government debt were over 4%, since which they have fallen to around 0.5%. Since yields and returns are inversely related, holders of such assets have seen a substantial increase in their capital value over that period.

UK investors who noted with relief that National Savings & Investments had postponed its intended rate cut from earlier this year in light of the pandemic will now have been notified of the reduction finally being applied from late November.  However, the cuts are now far greater than originally envisaged and move its returns into line with those of commercial institutions.

Investors seeking income therefore face three options:

  1. Learn to live with low rates as being the new normality and accept that there is nothing they can do to change them;
  2. Reduce their expectations for future returns on a temporary basis or
  3. Accept a higher degree of risk in pursuit of a higher income yield.

Accept the situation

For the first, a couple of options present themselves. One is to elect for index-linked gilts. These were introduced in the early 1980s and, provided they are purchased at issue and held to redemption, guarantee and inflation proofed income and capital return. While the yields are low in absolute terms, even a 4% yield on conventional bonds will not help much if inflation is 5%.

Another route is to hold shorter-dated bonds. The return difference between short (those maturing in under five years) and medium (5-15 years) bonds is not that great but the former exhibit considerably less price volatility, making them less vulnerable to the impact of future interest rate rises.

Reduced expectations

Institutional investors such as pension funds, which have an anticipated future stream of liabilities to meet, allow for the expected returns on various asset classes when constructing their portfolios. Reducing future bond yield expectations may lead them to construct a ladder of bonds to provide the opportunity of higher future returns. A bond ladder is a portfolio of bonds which mature at various dates in the future. For example, the portfolio might have maturities in 2023, 2026, 2029 and 2032. When the 2023 bonds mature, they are reinvested in an issue maturing in 2035 and in 2026, the maturity proceeds are reinvested in a 2038 maturity. This approach assumes that interest rates will not remain at their current levels forever and so affords the opportunity to move into what could be higher-yielding bonds over time. For the private investor, this requires more work than simply ‘buy and hold’ and does run into the potential issue of availability of stocks with the desired maturity dates. However, there are currently UK gilts available maturing in most years.

Taking more risk

The only way to achieve a higher return than cash is to take more risk than cash. While more risk leads to the potential of a higher return, it manifests itself in the possibility of a lower return or even a negative one. Investors who are willing to accept more risk have a few options:

The first is to invest in the bonds of riskier issuers. Fixed interest returns are a function principally of two risk factors, the time that you have to wait to have your capital returned (maturity risk) and the market’s perceived likelihood of the issuer failing to meet its obligations to you (default risk). Governments, since they have the ability to print money to meet future obligations (notwithstanding the risks to their economic stability from doing so), are generally perceived as lower risk than commercial businesses. Consequently, when the latter seek to raise capital, they need to make the offering sufficiently attractive to attract investors, so the yields on offer tend to be higher than equivalent government bonds. The more risky investors perceive the issuer to be, the greater the yield differential that is required. Having said that, highly rated corporate issuers fail infrequently and holding a diversified portfolio as always, provides some protection against this.

A second option is to consider preference shares. Although these can look like bonds in that they pay a fixed income, preference shares are a form of equity and so they carry similar risks as equity. Still, for a bond portfolio is overweight in high yield issues (also known as junk bonds), partially switching out of those into preference shares may prove worthwhile, particularly as they were hit hard along with other equities in early 2020 and not all have recovered their losses since.

Finally, there is the option to increase the portfolio’s allocation to equities. With the yield on the UK market now at around 3%, it may not take much of an increased equity allocation to replace income lost from bonds. Such a move may be made gradually, such as by gradual rebalancing or even by not rebalancing and allowing equity growth to move the allocation in that direction.

Nevertheless, increasing a portfolio’s allocation to equities, particularly beyond the extent to which your plan requires it, is not a decision to be taken lightly. We all have an emotional tolerance of investment risk and taking more than we are comfortable with increases the chances of having a wobble next time the market does. If you felt uncomfortable when the UK stockmarket dropped over 30% in March (given that nobody at the time knew how long it would take to recover and it is still 15% off its pre-fall level), consider how you would have felt with more of your assets exposed to it. If you can’t stick with any strategy that is there to help you achieve your goals

The reasons why investors hold bonds vary but in many cases, it is to dampen down the portfolio’s volatility rather than to increase its returns. A portfolio which you can live with is more effective than one which you can’t, as even if it has a higher return, you may have already baled out of it by the time it achieves the returns you need.

Pursuing yield is all well and good but also consider whether, for your own circumstances, it makes sense. What investors spend is cash. By the time that cash arrives in their bank account, its origin is unimportant. It may be more efficient from a tax perspective to spend realised capital gains (there is an individual annual exemption and the rate on gains above that figure is lower than the rate on the equivalent amount of income).

What matters in a financial plan is meeting current cashflow needs while minimising the impact on the ability to do so in the future. Any returns that the portfolio generates but which are not available to the investor (whether lost in costs or in taxes) are not going to help the latter.