Conal Gregory: Alternative routes to better returns in a low interest rate world

Those seeking a regular income stream are thwarted by the derisory bank and building society savings rates. The good news is that there are alternative routes which will deliver far better returns.

Diversification for income is critical. Annuities bring a guaranteed income but are inflexible whilst other choices include fixed interest, dividends, peer to peer, property and deposit accounts.

Company dividends or ‘equity income’ provide a key route. The income can rise as profits increase and firms are able to protect investors against the impact of inflation.

“Companies which produce a dividend tend to be better managed as the focus is on preserving the dividend which means taking less risks and concentrating on cash flow as well as shareholder interests,” says Adrian Lowcock, investment director at fund manager Architas.

Currently a significant number of the top 200 companies quoted on the London Stock Exchange pay yields over five per cent. They include Aberdeen Asset, Berkeley, Centrica, Cobham, HSBC, Inmarsat, Legal & General, Marks & Spencer, National Grid, Nex, Phoenix, Provident, Royal Mail, SSE and TP Icap. Several are even paying handsomely over seven per cent: Centamin, Pearson, TalkTalk.

Watch for companies, even large UK-based, whose dividends are partly uncovered. This means shareholders are not being paid out of profits but by debt or savings. When choosing a company mainly for its dividends, it is important that such income will continue and that the firm can afford to pay it as any cut will not only affect the money received but will probably cause a fall in the share price as investors sell up.

Some firms have struggled to maintain dividend payments but were ‘bailed out’ by sterling falling after the Brexit vote. With costs in sterling and profits in US dollars, the currency movement helped their balance sheets. If this position is reversed, there could be problems.

A fund is a safer way to invest, spreading your money across far more companies than most individuals could achieve otherwise. It reduces volatility and means that if a small number of holdings disappoint, the overall performance can still be attractive. There is little point in buying more than one UK equity income fund as each manager is looking.

The downside for the investor who wants income is that those assets which yield best are becoming ever more expensive.

“Fixed interest investments, such as gilts (Government stock) and corporate bonds, should have a place in most portfolios. They are particularly suited to more cautious investors, near or in retirement, or those who want to protect against stock market falls,” suggests Kelly Kirby, chartered financial planner at adviser Chase de Vere in Leeds.

Income from bonds is more stable than dividends but currently low since interest rates are miniscule. Corporate ones are unexciting as they are using the low borrowing environment to issue longer-dated bonds at tiny yields.

For greater returns, it is necessary to seek high yield bonds or emerging market ones, both bringing increased risk. Just like equity income, a collective is a less risky way to proceed. Juliet Schooling Latter, head of research at discount broker Chelsea Financial Services, has tracked down two bond funds which pay fair returns:

Invesco Perpetual Monthly which can invest up to 20 per cent in equities, yielding 5 per cent;

Schroder High Yield Opportunities, yielding six per cent.

Seven Investment Management creates portfolios based upon a client’s attitude to risk. For fixed interest, its ‘moderately cautious’ selection includes Babson US High Yield Bond, Fair Oaks Income, Lloyds Bank 1.75 per cent March 2022 and US Treasury 2.25 per cent February 2027.

Avoid bonds issued by building societies, known as permanent income bearing shares or PIBS. As both the Manchester and West Bromwich Building Societies have shown, they can walk away from paying interest. Investors can also find such respected issuers will not redeem their money. PIBS are not covered by the Financial Services Compensation Scheme.

With slow growth of only 1.7 per cent in the UK and concerns over the effects of Brexit, a stronger income stream is likely elsewhere. By comparison, in its latest update, the IMF forecasts global growth of 3.5 per cent this year and 3.6 per cent next, boosted by continental Europe and emerging markets.

There are sectors like developed technology which produce an income but are not accessible in the UK.

Lowcock likes MI Chelverton UK Equity Income whether you are seeking income or growth. It invests primarily in mid-sized and small firms which yield at least four per cent. The managers source reliable if ‘boring’ income payers. For growth investors, the benefit is gained through reinvesting the dividends. Overall the fund yields 4.09 per cent.

To not take dividends gives a major boost to any portfolio. Whilst the FTSE 100 has increased 18.6 per cent in a decade, money invested there over the same period has jumped more than 74 per cent with the dividends reinvested.

For a fund based on all sizes of UK company with an outstanding track record of raising its own dividend, Rathbone Income is Schooling Latter’s choice. It pays 3.4 per cent and has increased its dividend in 23 of the past 24 years. She also tips the City of London Investment Trust which has raised its dividend for over half a century and always has the back-up revenue reserve should conditions tighten. It yields 3.9 per cent.

Lowcock’s tip for a risk-averse fund based on companies which offer sustainable growing dividends and a consistent cash flow is Fidelity Global Dividend. With a defensive style of investing, it performs better in weaker markets and currently yields 2.8 per cent. A rival is Guinness Global Equity Income which pays the same yield.

There are also hybrid funds where some of the capital growth is sacrificed to boost income. They are likely to underperform when markets are rising and vice versa.

Two examples are Fidelity Enhanced Income and Schroder Income Maximiser.

For a bond approach, Artemis Strategic Bond is run by James Foster who has almost 20 years of bond investment experience. Tipped by Lowcock, Foster can buy anywhere in the bond market, giving a flexibility which is ideal to create a balanced fund. It currently yields four per cent.

Commercial property can provide a good yield with growth prospects but more risk is being taken on. It is important to understand where a property fund invests, such as the shares of quoted companies or actual bricks and mortar. Two funds Kirby tips are Henderson UK Property and M&G Property Portfolio.

If you want to see a tangible asset, buy-to-let is an option but, apart from the changing tax position, there can be prolonged periods if no tenant can be found.