With UK interest rates having fallen to a record low of 0.25%, it is becoming increasingly challenging for investors to secure a consistent level of income on their savings.
Bonds would be an obvious place to start searching for income. However, Quantitative Easing (QE) has depressed yields due to an increased level of government intervention. Whilst sovereign bonds in the UK and the US still provide reasonable income in comparison to cash, at around 1.2% and 2.5% respectively for a medium dated security, many shorter dated bonds have seen their yields driven into negative territory, partciularly in Europe and Japan, as a result of QE. Corporate bonds offer better yields, although the level of risk is higher in comparison to sovereign debt as historically such bonds will carry a higher risk of default. Investors can currently achieve yields of around 3.5% to 4.0% for diversified funds which invest in this sector. A final option is to invest in index linked securities, which benefit from higher inflation. At current prices, Index Linked Gilts currently require annual inflation of around 3% per annum for investors to break even. In the US, however, the breakeven rate is only 2%.
Equities provide another established source of income. Our preference would be to invest in companies which offer dividend payments which are well covered by earnings and free cash flow. This means that if times get tough, the dividend is less likely to be cut. Although the headline yield of the UK top 100 companies is currently 3.6%, a careful approach is warranted. Many companies, including the likes of BP and AstraZeneca, have recently issued debt in order to fund their dividend payments. Whilst this may work in the short term, if profits do not improve, it is an unsustainable long-term strategy. Dividends may be cut if balance sheets continue to deteriorate.
Finally, investors may consider investing in alternative assets. Gold is a proven diversifier of investment returns and helps to dampen portfolio volatility. On the downside, it does not provide an income. Infrastructure funds, linked to projects or equities, generally do provide an income and can also help to reduce portfolio volatility. Currently, yields of around 4.0% to 5.0% can be achieved.