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Investing for an income as interest rates stay grounded

Graham Smith

Graham Smith - Market Commentator

Central banks had nothing to offer beleaguered cash savers this week, with decisions to cut or maintain interest rates spurred on by the latest brace of economic uncertainties.

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This problem is really nothing new. Owing to the financial crisis of ten years ago and the shallow economic recovery that has followed, inflation has stayed grounded and below the confines that we might have expected during the recovery phase of the economic cycle.

The biggest turnaround in expectations this year has been in the US. As recently as in December, several interest rate rises in 2019 – perhaps as many as four – appeared likely. However, in the continuing absence of excess inflationary pressures, even as the economy has continued to grow, US rates have now been cut twice since July.     

Coupled with the European Central Bank’s decision last week to marginally reduce interest rates and renew its programme of asset purchases with freshly printed euros – in other words, quantitative easing – fresh hopes for some respite from historically low returns from cash have, once again, been thwarted.     

All this is doubly bad news for people approaching retirement. Annuities remain the only way of converting a defined contribution pension pot into a guaranteed income for life, but a combination of increased life expectancy and low government bond yields – the latter being linked to interest rates and inflation expectations – has driven the monthly amounts pensioners can expect to receive from an annuity down to record low levels¹.

The only saving grace is that, thanks to the government’s introduction of “pension freedom” in 2015, there are now other options open to pension savers – albeit without absolute guarantees. One option is to only use part of a pension pot to buy an annuity, while leaving the remainder in “drawdown” to be used as and when it is needed.

This strategy could be used to help cover off basic expenses via an annuity, while retaining the flexibility to draw down other parts of a pension pot to fund more major purchases or to assist with a change in circumstances requiring a greater income – for example, increased housing or healthcare costs.

In this kind of environment, It’s no wonder that, for investors of all ages, equity income funds remain a popular choice. According to latest Investment Association figures, UK investors have more than £50 billion invested in UK equity income funds and just over £18 billion in global equity income funds².

Owning individual shares in companies paying attractive dividends may be an option for some, but for many others the associated risks to capital are too high. A well managed income fund can reduce, though not eliminate, these risks and provide a semi-annual or quarterly income that grows over time – something that cannot be achieved either through holding cash savings or fixed rate bonds.

Fidelity’s Select 50 list of favourite funds highlights some of the options available, along with the fact that not all income funds are built the same way. It’s important to understand the differences, because these funds can behave differently from one another over time depending on how they are put together.

Some funds concentrate almost solely on identifying and investing in the high yielding shares of companies expected to sustain or grow their dividends over time. Others allocate a certain proportion to higher yielding shares to provide income and another part of the portfolio to shares more likely to deliver income growth. In some cases, income funds may also invest in a selection of corporate bonds to increase yield, or use financial instruments to deliver an additional income stream.  

Owing partly to the Brexit uncertainties that have conspired to keep many UK share prices in check over the past three years, each equity income fund on the Select 50 list currently offers a highly attractive yield (distributions per fund unit or share over one year divided by fund price). Yields are also comfortably above the levels of interest that savers can expect to receive from cash or fixed rate bonds, as well as the current rate of inflation – 1.7% last month³.     

The JOHCM UK Equity Income Fund currently yields around 6% net⁴. As with any other equity income fund, distributions are not guaranteed and will vary.

This fund invests only in stocks expected to yield more than the FTSE All-Share Index in future. Every stock also has to have the potential to deliver capital appreciation. This naturally leads to a contrarian investment style, whereby stocks undervalued or underappreciated by the market as a whole find favour.

The Fidelity Enhanced Income Fund also has a preference for undervalued stocks, which not only pay good dividends but grow them year by year. The Fund achieves a higher yield – currently around 7% – partly through the sale of financial instruments related to its underlying investments (covered call options).

The Franklin UK Equity Income Fund pursues a hybrid strategy, with some stocks having a dividend yield greater than the market as a whole and others that are growing their dividends faster than the overall market. Owing to this, the portfolio provides an exposure to defensive shares as well as shares more sensitive to changes in the economy. The Fund currently yields around 4.6% net⁵.

Sources:
¹ Moneyfacts.co.uk, 10.09.19
² Investment Association, September 2019
³ ONS, 18.09.19
⁴ JO Hambro Capital Management, 31.08.19
⁵ Franklin Templeton, 31.08.19

Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Select 50 is not a personal recommendation to buy or sell a fund. The Fidelity Enhanced Income Fund uses financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The funds do not offer any guarantee or protection with respect to return, capital preservation, stable net asset value or volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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