Pensioners, and other people on low and fixed incomes have taken a battering in 2008. First of all there was a spike in inflation in the opening six months of the year and now there have been significant falls in interest rate returns. As a result returns on bank and building society cash deposits are today very much lower than they were 12 months ago. The Bank of England Base Rate is now at just 2%, its lowest for 58 years. At the same time UK interest rates are likely to go lower – even if the Bank Base Rate does not fall. And that’s because the gap between the Bank Base Rate and the London Interbank Offered Rate (commonly called LIBOR) is still wide and will diminish. It’s the rate at which banks and building societies borrow and lend money between each other (normally 3 months LIBOR) and the gap between that rate of around 4% and Bank Base Rate at 2% is likely to fall as banks and building societies regain confidence to deal with each other.
So how can income-seekers combat a trend of further reductions in interest rate receipts? The answer is with difficulty but they might consider the merits of:-
High Yielding Corporate Bond Funds Within ISAs
One after-shock of the so-called “credit crunch” is that today high yielding fixed interest securities, commonly called corporate bonds, are yielding 10% plus. So if you invest, say, a full ISA allowance of £7,200 in a corporate bond yielding 10%, you obviously receive an annual income (often paid monthly) of £720. But how much cash would you need to obtain the same post-tax return from an ordinary bank or building society account? If you obtain a post-tax return of 3%, the answer is £24,000.
Of course there is a big difference between a high yielding corporate bond fund and a bank or building society cash account. The first is a risk investment and the second should not be. Nevertheless, with the prospect of a further fall in the bank Base Rate and a further narrowing of the gap between the bank Base Rate and LIBOR, I think there is a case for investors to consider high yielding corporate bonds particularly following the sharp drop in their value in October.
Why did they fall so sharply then? Up until the end of September 2008 these bonds had weathered the credit crunch remarkably well but then seemed to fall victim to wholesale selling of almost every saleable investment by overstretched investors and highly indebted hedge funds. The fall in October prices emphasises that corporate bonds are a risk investment although probably less risky than equities.
So what are the good and bad points about high yielding corporate bonds and are they really a possible substitute for cash accounts?
Good Points
Over the past
- Over the past 5 years or so most leading companies that issue corporate bonds have dramatically improved their balance sheets and profitability and so are better able to weather a period of recession than they could, say, at the end of the 20th Century;
- For some time now there have not been many mega-bids which, again, 8 years or so, produced large amounts of junk debt to finance mergers;
- As we go into recession, it is clearly evident from daily news stories that companies are cutting costs and that all too often means cutting staff numbers;
- A sharp fall in corporate bond prices in October has made the managers of many high yielding corporate bonds dramatically re-orientate their portfolios. So at the moment many of them have sizeable holdings of AAA rated fixed interest paper and that means not only UK Government securities commonly called gilts but also stock issued by, for example, the European Investment Bank.
On a technical note, fixed interest securities are broken down into investment and non-investment grades. The investment grade goes from AAA at the top down to BBB and non-investment grades go from BB to junk status.
Bad Points
One the main reasons for a recession is less consumer spending which will obviously put pressure on company profits and profit margins. One critical guide to investing in corporate bonds is the risk of credit default. This means not just when a company stops paying interest but also if it breaches any additional covenants linked to the quoted loan stock it issues. Those covenants can, for example, include profit ratios and minimum asset value figures.
So it is my suggestion that, for the right investor, with significant cash holdings, there may be a case for using the full ISA allowance to build up a new source of high income from corporate bonds. I believe the risk/ratio now in these bonds is attractive if investors are looking for new and better sources of investment income.
I must, of course, warn readers of this blog that corporate bond funds are risk investments and that they can go down as well as up in value and past performance is not necessarily a guide to future performance.
Let me know what you think about this suggestion. This idea is not for everybody and is not for the ultra-cautious but it may be an answer to some peoples’ needs for more income to offset a sharp loss of income on bank and building society accounts.
