Isa tips for 2017: how to achieve a 5pc income
17 February 2017 • 10:16am
Earning an income of £5,000 from a £100,000 pot used to be fairly normal, but in today’s environment it is a tall order. To achieve this, investors need to take more risks than they might imagine. The Bank of England’s emergency measures to cut Bank Rate to record lows and to launch quantitative easing, now in place for a decade, have forced the return on cash ever lower. In 2007, just before the financial crisis, the average one-year rate for a cash Isa was 5.5pc. Today, the very best rates available are around 1pc – over 80pc lower. That means an Isa saver who wants any hope of securing a 5pc yield must be exposed to the stock market through a stocks and shares account. As investors have hunted for yield, they have all crowded into familiar “blue chip” names that pay a steady income, making them expensive. The price to earnings ratio, a way to value the relative expense of a stock or market, is 18 for the FTSE All Share index, against a long-term average of 14. As yield works inversely to price, that move to push prices up has meant yields have fallen. This means yield-hungry investors must venture away from the familiar stocks to get their income. The same is true of other assets, such as retail bonds and “open-ended” funds or investment trusts that focus on geographical areas or sectors ordinary investors will have less knowledge of. An important distinction also needs to be made between the income produced by an investment as opposed to its total return. The latter is the performance measure most commonly used as it combines capital growth as well as earnings through dividends paid to shareholders or interest to bondholders. For longer-term investors, focusing on total return is the normal course of action, but targeting an income is another matter. Pensioners, for instance, are likely to have a greater need for immediate income, as opposed to younger investors who are still accumulating wealth and are therefore keen to reinvest any income to harness the benefits of “compound averaging”. “DIY investors have to accept they will need to take a greater level of risk to achieve 5pc,” said Ryan Hughes, of AJ Bell, the fund shop. “That’s borne out when you look at the UK equity income sector where there are only four funds that are yielding more than 5pc.” Telegraph Money takes you through the places where 5pc is still achievable.
StocksExamples of the high price investors must stump up for dependable income are everywhere. Take Diageo, the drinks giant behind brands such as Guinness and Smirnoff. It has a dividend yield of just 2.6pc and, at today’s price of £22.50 a share, trades at nearly 25 times earnings. This is up from a price to earnings ratio of 11 in 2009. Instead, investors can hunt the wider FTSE 350 index for dividend yield, based on stock market analysts’ expectations in the coming year. This data is from Bloomberg, the financial data provider. A total of 16pc of the index is currently paying 5pc or more.
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Construction firm Carillion and house-builder Taylor Wimpey top the list, with 8.5pc and 7.8pc expected yields over 2017. But Laith Khalaf, of broker Hargreaves Lansdown, warned that investors should not just look at the yield figure. “Investors should pay heed to the longer term prospects of the companies they are investing in, because if a company’s profits start to fall, that impacts its ability to pay dividends,” he said. Of those firms expected to yield more than 5pc Mr Khalaf picked Lloyds, which has a 5.2pc projected yield. He said profits were rising with steadier high-street banking, business lending and personal finance, while regulatory fines for past misconduct should “fade into the background”.
FundsOf the four funds in the popular UK equity income sector yielding more than 5pc, the £1.1bn Schroder Income Maximiser (yielding 6.8pc) and £500m Fidelity Enhanced Income (6.4pc) are the biggest and best known. But, warned Mr Hughes, these funds – spin-offs of more traditional funds targeting total returns – are wholly focused on income. This means they give up some of the potential for capital growth in favour of paying out to investors. “When you look at their non-income peers on a total return basis, they will lag over the long term,” he said. Both funds use a complicated type of derivative contract called “covered calls”. These “options” are used by few fund managers as a central part of the overall strategy. The derivatives mean the fund has a guaranteed income to pass on to investors, but the fund will miss out if its holdings do spectacularly well. There is more choice among funds in the high-yield corporate bond sector, where 13 funds are currently yielding over 5pc.
These include the £110m Aberdeen European high-yield bond (6.3pc yield), which invests in debt issued by companies across Europe, especially Britain. Over five years it has beaten its benchmark by 10 percentage points, at a total return of 45pc. Another attraction of bond funds, said Mr Hughes, is the wider choice of how regularly income is paid. “You can find bond funds that pay annually, biannually, quarterly and even monthly, and that can be particularly appealing for investors who need income for day-to-day expenses,” he said. Yet Brian Dennehy, of FundExpert, a fund research service, said his firm did not often recommend its clients use bond funds. “We think a bond fund yielding 5pc is more risky than an equity fund yielding 5pc. Inherently, there isn’t opportunity for growth in the income of a bond fund,” he said. Among investment trusts – which trade on the stock market – Alan Brierley, an investment trust analyst at Canaccord Genuity, the broker, pointed to the trusts in the renewable infrastructure sector. All these funds yield over 5pc. He said: “Greencoat UK Wind and Renewables Infrastructure Group are the two largest and provide attractive yields of 5.4pc and 5.7pc. When they were set up these companies were structured to pay out their revenue as a priority over capital growth.” One downside of the sector currently, is that all of the companies are trading at a premium. This means that they are trading at a higher price than the value of their assets (11pc in the case of Renewables). Funds focused on commercial property have long been seen as a source of income.
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But the sector was plunged into a minor crisis in the wake of the vote to leave the EU as some “open-ended” funds put restrictions in place to stop an exodus of investors over fears of a slow down in Britain’s property market. Without large cash reserves, the funds needed to sell their properties to meet redemptions. Investors were either faced with a complete block or “gate” on their money, or the option of withdrawing at a significant discount. In contrast, investors in “closed-ended” funds like investment trusts remained free to sell their shares at market rate, albeit at a large discount. Regional REIT is one closed-ended fund that holds a portfolio of more than 100 offices and nearly 1,000 industrial units outside of the M25. It has a dividend yield of 6.8pc, although it is currently trading at a 3.2pc discount. Despite both yielding just under 5pc, Mr Dennehy recommended the Threadneedle UK Property and Kames Property Income funds as opened-ended alternatives. Both have little exposure to London, which is predicted to suffer the most from a lack of foreign investment in the wake of Brexit. He added that the reaction to the property fund restrictions last summer was overblown. “Everyone knows property is illiquid, that it takes time to sell. The funds that applied discounts did so to protect investors. The reaction from the regulator and commentators was over the top,” he said.