Investors are faced with a dilemma. For six years the Bank of England’s record-low interest rate of 0.5 per cent, combined with loose monetary policy around the world, has suppressed bond yields and starved investors of income.
In an era of high government debt, low inflation and sluggish global growth, investors are flocking into higher risk assets that pay an income, pushing up prices and causing yields to fall across the board.
Unfortunately, things seem unlikely to improve for some time. Cheaper oil and falling food prices have caused inflation to fall to new lows in recent months, all but dashing hopes that the official bank rate will go up before the year’s end.
The impact of low inflation, economic growth and interest rates, as well as quantitative easing, has been to push bond yields to ever lower levels. Interest rates paid on savings accounts have also all but dried up and annuity rates, which are tied to bond yields, have fallen to meagre levels.
Where can an investor find value in today’s markets? In an environment of sustained low inflation, investors will need to get used to achieving a lower level of income from all asset classes.
In the past, investors could rely on government bonds to provide a reasonable yield while also acting as a safe haven in times of uncertainty. But returns in this market are expected to be paltry for the next five to 10 years, a reflection that bond prices have climbed to historically high levels, leaving limited scope for further gains.
In fact, many short-dated European government bonds have negative yields to maturity, such as those in Denmark, France and Germany, helped along by quantitative easing by the European Central Bank.
We have even seen the yields on five-year German bunds turn negative, while longer-dated bonds are offering only marginally more attractive yields. Ten-year UK gilts are yielding just 1.8 per cent – hardly an attractive level to sustain a retirement income.
Nevertheless, on the positive side, UK gilts do at least offer a real return in excess of current inflation. And in any kind of global financial crisis, do not rule out their status as safe haven assets driving their prices higher and yields lower.
For investors willing to take on more risk, equity income stands as a viable alternative. At 3.3 per cent, the yield from the FTSE All-Share index appears more attractive than sovereign bonds from developed economies – low compared to the past, but there are opportunities for this yield to grow over time.
It should not be a surprise to see that the UK Equity Income sector was the best seller for the Investment Association last year.
One of the more attractive asset classes for income at this time is commercial property, which currently offers a yield of around 4-5 per cent. While 2014 was an exceptional year for commercial property investors with returns of around 19 per cent, it is safe to say that growth from here is likely to prove more challenging.
