The Big Squeeze

Travel back about 30 years and UK government bonds were paying yields of around 10%, 20 years ago it was around 7%, while 10 years ago it was around 5%. Following the global financial crisis, government bond yields dropped again, to 2% by the end of 2011 and down to around 1% today. To be fair, inflation has dropped as well, but the real yield, the amount left after inflation, has plummeted.

It’s tempting, then, for income investors to move into something a little more risky in the fixed income space such as corporate bonds, but unfortunately the story is much the same there. Moving up the ladder, high yield bonds can have cycles of very low defaults, then periods of high defaults. At this point people remember why they were originally called ‘junk’ bonds. So they can provide attractive income, but it’s not always stable.

In the UK, using equities as a source of income has been popular for a while as UK stocks have a relatively high and stable dividend, and with fixed income yields so low equity yields are actually higher than in fixed income. But again there are risks to equity investments that should not be taken lightly. While the dividends from equities tend to grow over time and are typically kept stable from year to year, in deep economic downturns they can be cut aggressively.

So what’s an investor to do? Instead of focusing on a single asset class, using multiple asset classes has now become increasingly popular for building income-orientated portfolios. By combining different asset classes, a portfolio can deliver a smoother income profile, diversify risks associated with a single asset class investment to preserve capital when markets fall, and seek attractive sources of income through the market cycle by shifting the asset allocation over time.

Having such a broad investment universe, however, does make income investing far more labour intensive – much like wading through today’s hundreds of available Freeview channels!

In my next blog piece, I’ll talk about the dangers of targeting a fixed yield level, because if you do so you’re likely to miss the bigger picture.