Gilts at 1.4%- Where Do Investors Go for Income?

If that doesn’t sound particularly appealing, and you believe the Bank of England will hit its 2% inflation target over the next 10 years (don’t laugh), the money the government returns to you will be worth less than when you gave it to them.

If you want to get your money in the meantime, you will have to sell at the market price, which could mean even less if interest rates rise.

Laith Khalaf, Senior Analyst, Hargreaves Lansdown:

‘You don’t have to be mad to buy gilts, but it helps. Rational investors wouldn’t touch gilts at this level, but reason is pretty much out the window when central banks are sporadically firing bazookas at government bond markets.

However plenty of well-respected, rational fund managers have been caught out by calling time on the gilt market, starting with Bill Gross, who told us five years ago the UK government bond market sat on a bed of nitroglycerine. The 10 year gilt yield at the time stood at 4%, quite a tantalising prospect by today’s standards.

Despite the unflappable ability of the bond market to confound reasonable expectations, we would still advise investors to be wary of investing in government bonds. For long term investors, equities simply look a much better bet, if you can ride out the ups and downs.

Investors looking for bond exposure should consider strategic bond funds, which have the flexibility to invest across the bond spectrum and hence to dodge the worst of any carnage in the bond market, providing the fund manager is on his toes.’

Why have gilt yields fallen?

Falling inflation, lower growth expectations, and of course the ECB bond-buying programme are the most likely culprits for the fall in bond yields.

CPI inflation has fallen to just 0.5%, largely a result of lower oil prices. UK economic growth slowed to 0.5% in the final quarter of 2014. And ECB President Mario Draghi has announced a 1 trillion euro government bond buying programme.

The ECB won’t be buying UK bonds, but the QE programme has prompted a decline in the German 10 year government bond yield from 0.5% to 0.36%. This makes the UK more attractive by comparison, and yields fall as more money flows in that direction.

The 10 year yield at 1.4% does make sense if you believe the UK is set for an extended period of low inflation, or indeed deflation.

Alternatives for income-seekers

The unappealing return available from gilts probably goes some way to explaining the popularity of UK Equity Income and Property funds in recent times.

UK Equity Income was the best-selling UK sector in 2014, according to the Investment Association, with funds seeing £6.3 billion of inflows. Meanwhile property funds saw £3.8 billion of inflows, the highest figure ever for this sector.

The main alternatives to government bonds for income-seekers are as follows:

1. Cash

Cash won’t fall in value, but it won’t return very much at the moment. All savers should hold some money in cash as a buffer to fund short term spending needs. However, long term investors are likely to get short shrift from holding cash, particularly once you take inflation into account.

The pensioner bonds from NS&I look like a good option for over 65s, but they are taxable. Cash ISA returns aren’t particularly attractive, but they are tax-free. Using your ISA allowance also means that if rates rise in the future, or you become a higher rate taxpayer, that ISA wrapper really pays off by shielding you from even more tax.

You can also now transfer from a cash ISA to a stocks and shares ISA, and back again. Last year we saw a 48% increase in transfers into our stocks and shares ISA, as savers flee from low cash rates in search of better long term returns.

2. Bonds

The 10 year government bond currently yields 1.4%. The yield on the average investment grade corporate bond funds currently stands at 2.8%, on the average high yield bond fund it stands at 4.3%.

None of these look particularly attractive, given the risks involved. However, as mentioned above, that hasn’t prevented bonds from beating expectations in the recent past.

For some investors, bonds make up part of a balanced portfolio, though we would suggest they look to strategic bond funds run by seasoned managers, such as Invesco Perpetual Tactical and M&G Optimal Income. These funds have the flexibility to invest across the bond spectrum, harvesting opportunities and avoiding pitfalls where possible.

3. Property

Property has been very popular of late, as it is an alternative to gilts in terms of both income generation and diversification. Property funds are currently yielding 3-4%.

Property fund investor should be aware that the costs of investing in this asset class are high, and will erode returns over time.

Property is also an illiquid asset, which means if you hold it via an open-ended fund, you might have to wait for your money when you encash the fund, if there is a stampede for the exit. For this reason, and because of heavy inflows into the sector, some property funds are holding in excess of 10% of the fund in cash, which is likely to hamper long term returns.

Investment trust investors don’t face the same wait to encash their funds, which they can do at market price throughout each trading day, though in times of distress this price is likely to be less than the value of the portfolio of properties their fund is invested in.

4. Equities

Equities look relatively attractive on a yield basis for long term investors. The FTSE All Share yields 3.8%, with the FTSE 100 yielding 4%.

While share dividends can, and do fall, over the long term if properly managed they have the potential to grow significantly, as does your initial capital investment.

Equity income funds are a good core holding for long term investors seeking income, and those seeking total returns.

A £10,000 investment in Artemis Income at launch in 2000 would now be generating an income of £795, an effective yield on your initial investment of almost 8%.

Over the course of the last 15 years you would have received a total income of £9,180, almost your initial investment back in income alone.

And the real kicker is your fund would now be worth £21,160.

Investors who want to invest in equity income funds might consider Artemis Income, Woodford Equity Income, and Newton Global Higher income.

Investing in these funds via an ISA means your gains are free from capital gains tax, and higher rate taxpayers save 22.5% income tax on dividends.