Interest rate misery for savers
Q: My income has dropped significantly from my building society account. What are the alternatives if I need to generate income?
A: The latest cut in interest rates, leading to the lowest rate for three centuries has brought about misery to the thousands of people who rely on bank and building society interest to supplement their incomes.
The possibility of further cuts, coupled with an increasingly longer recession than many had first predicted, also leads me to believe that the prospect of any dramatic rise in the short term is highly unlikely.
Investors who had the foresight to lock into higher rates when the lenders were scrambling around to attract funds benefited from these high interest offers, and only 12 months ago were able to achieve somewhere in the order of seven percent.
As these monies mature, people will be shocked to find out how little they can now achieve and are faced with a real dilemma. Do you cut your income substantially, or start to eat into capital?
Such investors face another dilemma, in the form of protecting their capital in real terms. This means ensuring that inflation does not erode their savings.
If inflation is averaging 4%, and the income they are withdrawing after tax is say another four percent, then in real terms they need to achieve a return of 8% after tax just to stay still.
Such dilemmas are causing investors to consider moving some of their capital out of cash into other asset classes.
The problem here is that other assets do not normally offer capital protection in the same way as cash does, but by remaining in cash in the current climate, capital is in reality being eroded anyway.
A popular option at the minute is to consider what are known as corporate bonds. A corporate bond is effectively an IOU from a company to its investor. In return for lending the cash, the company will pay a fixed rate of interest of a fixed period of time.
The risk therefore is that the company goes into administration and can neither pay the ongoing interest or the money it owes to its investors.
This risk can be minimised by selecting bonds that under normal circumstances are backed by companies that have strong balance sheets. These are known as investment grade bonds.
The current climate means that even these types of companies are being viewed as having a high default rate, which is leading to attractive returns for the investor.
A typical investment grade corporate bond is currently showing an income yield typically in excess of 5%. This is very favourable when compared to typical deposit rates.
For those willing to take more of a risk, there are also high yielding bonds. These pay a higher rate of return on the premise that the default rate is potentially greater.
High yield bonds typically pay a return of around 10% at present, due to the fact that they carry a higher risk to capital.
The best method of accessing corporate bonds is to invest in a corporate bond fund. This means that your monies buy a number of bonds with other investors and thus your investment risk is spread further.
These funds are managed by a professional fund manager who has the experience and track record of investing in this area.
A number of these funds exist and again it is important to consider a fund with a good track record. This is no guarantee going forward but offers the best indication.
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 firstname.lastname@example.org or (028) 9022-1010