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Generate income, preserve capital

By Raymond Mulligan

QUESTION: I have once again found my income being cut as a result of the drop in interest rates. What should I do to protect myself from further falls?

ANSWER: It is amazing to see what has happened over these last few months with regards interest rates. We went through a period where rates were being kept up due to inflationary pressures and now we find ourselves talking about possible deflation, and rates falling to a 60 year low.

The move by the Bank of England to cut rates took no one by surprise. Many commentators are asking if there are still further to come. While further cuts are welcomed by those with borrowings or businesses that are looking for the economy to be further stimulated, it is as you point out, at the expense of those who have worked hard to save for issues such as retirement.

Many people have chosen to build up savings in cash for one reason, that it provides security of capital.

Despite the recent issues faced by the banking sector, failing the collapse of the institution, an investment in cash provides an absolute guarantee.

In recent years, with relatively high rates and low inflation, an investor was assured a real rate of return on their investment. By that I mean their investment after tax, kept pace and on occasions outstripped inflation. This is the ultimate aim of any investment.

Now however the tables have been firmly turned and cash investors are finding their money losing value in real terms, even before they seek to draw of an income from it.

The dilemma faced by many however, is that to consider alternative investments will mean losing the security of capital.

So if this is of utmost importance what you should be doing now is to look to lock into whatever rates you can for say the next 12 months.

Fortunately many banks and building societies are keeping relatively attractive rates as they seek to shore up their deposits to help with their lending requirements. The credit crunch has meant the rate at which banks lend to each other has remained high, despite the cuts, so many institutions are seeking to raise funds by attracting inflows of deposits, as this can be a cheaper way of raising finance.

If you can afford to put some or all of your capital at risk there are a number of alternative investments that will seek to provide real returns over the longer term.

Many of these assets are looking cheap at present due to the dramatic falls we have witnessed in 2008. Not all of these alternatives are stock market based either.

As I mentioned recently, corporate bonds, which are in effect an IOU given by a limited company are providing some abnormally high returns at present.

These can provide an investor with a return at present significantly higher than deposit rates, and at the same time offer the prospect for capital growth.

The main difference however lies in the fact that these investments cannot guarantee your capital.

What someone in your position should be doing at present is to sit down with an adviser and put together a strategy that not only matches your risk profile, but will meet your objectives over the longer term. This will involve balancing the need to generate income, whilst at the same time preserving your capital not only in nominal, but in real terms.

Raymond Mulligan is managing director of Johnston Campbell, a company of independent financial advisers regulated by the Financial Services Authority. For further information, please contact or (028) 90221010

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