A new way of thinking about income

Interest rates and bond yields headed to the floor in the wake of the global financial crisis and have more or less stayed there since. In this “new normal”, generating a sufficient income may require new ways of thinking.

Man watering money plants - Rathbone Investment Management

Jane Sydenham, Investment Director, Rathbones

Many investors like the idea of preserving their capital and living off the income it generates. But ultra-low interest rates and bond yields mean it may now be more helpful to think in terms of total returns, which include both capital growth and income.

It may be safer too. The corollary of extremely low bond yields is extremely high bond prices, as the two move inversely. This means that traditional income-generating assets like government and high-quality corporate bonds may not be as safe as they are perceived to be.

Here we try to answer some of the questions that clients may be asking:

Say an annual inflation-adjusted income of 2% of a portfolio is needed — would the yield from a typical income portfolio be high enough?

Current yields on traditional income-generating assets are not sufficient, and are unlikely to rise enough in the foreseeable future to produce a 2% income after inflation. To generate 5% (based on average inflation plus 2%) would require either moving down the credit-quality scale within fixed income, or investing in high-dividend-paying equities. Both of these would mean taking on considerable risk.

How else can sufficient cash be generated?

We need to look at a combination of income and capital growth. A properly diversified mix of assets, one that has a greater risk-adjusted potential for total returns than traditional income-generating assets like bonds, can also have good defensive characteristics. For example, an investment portfolio can hold non-bond assets with low or even negative correlations to equity markets. So when equities are falling, these assets (for example certain trend-following, macro-economic and other alternative strategies) would tend to be more stable, or even produce positive returns.

From such a diversified portfolio, it is possible to draw a moderate amount of cash without eating into the total value of the capital in the portfolio.

But if capital is drawn down, surely that has to reduce the value of the portfolio?

Although past performance is not a guarantee of future returns, potential total returns can be increased by investing in assets that have historically generated higher annualised total returns (of income plus capital) than more defensive assets like bonds. A sufficiently higher return (compared to bonds) could provide the same level of cash and still boost the value of the portfolio after a modest drawdown.

For example, a typical Rathbones balanced portfolio that mixes bonds and equities and other assets has a long-term expected annualised total return of consumer price inflation (CPI) plus 3%. Let's assume that CPI is 2%. That means a total return of 5%. Assuming 2% of that is the income yield, a £500,000 portfolio should generate a gross annual income of £10,000. On average, that £500,000 portfolio would still have grown by inflation plus 1% after the capital withdrawal, still producing a real capital gain. So this would be a sustainable level of withdrawal.

Compare that with a £500,000 holding in an AA-rated (high-quality) 10-year corporate bond, which would currently yield about 1.1%. That would generate a gross annual income of £5,500. Not only would the initial capital of £100,000 be unchanged, it would be worth less in real terms after taking into consideration the impact of inflation.

What if there is a downturn in the market?

While major government bonds and high-quality corporate debt have traditionally been considered safe in terms of default risk, their current valuations leave them vulnerable to some capital losses. Income-generating assets are only one kind of investment, and a better-diversified portfolio could potentially provide more protection on the downside.

What about dividends? Don’t these pay out more income than bonds these days?

It is true that dividends from UK equities, as measured by the FTSE All Share index, currently pay more than triple the yield on 10-year gilts (3.5% versus 1.1%).

However, an all-equity or equity-tilted portfolio would have a higher risk of losses compared to a well-diversified portfolio, and would therefore be inappropriate if the aim is to preserve capital and generate an income.

In the case of the FTSE, a closer look reveals that a big contributor to the current dividend yield is the energy sector, which makes up about 12% of the FTSE All Share broad UK equity index. These dividends may therefore be vulnerable to renewed or sustained weakness in oil prices. This demonstrates how chasing yield can bring unintended exposures and risks.

How will drawing cash from capital instead of relying on income-generating assets affect tax liabilities?

Taking a modest drawdown from capital can actually be a more tax-efficient way of generating cash compared to income-generating assets. This is because the rates for capital gains are lower (10-20%) than those for income tax (20-45%), with actual rates depending on individual circumstances.

Is now a good time to make a significant shift in asset allocation?

Bond valuations are at historically expensive levels so now may be a good time to take profit and reinvest the proceeds in assets that can offer better value, and a higher risk-adjusted return potential.

Think of a portfolio as a cake that is growing. If it is growing at a sufficient rate, a slice can be taken without reducing the overall amount of cake. Indeed, if it is growing fast enough, you can still end up with more cake.

We have to accept returns and growth may not be excessive at this stage of the economic cycle. But if we stop thinking just about yields and interest alone and think about the total picture, our portfolios can still meet sensible expectations and needs without the need to take on undue levels of risk.

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