Where do I invest in the low interest, low growth world?

At the start of 2014, the Bank of England was expected to start hiking interest rates from their historic lows. However, while the improvement in the UK economy was sustained last year, Europe’s recovery faltered and inflation remained subdued due to falling commodity prices. There is unlikely to be any respite for savers this year, with the market now predicting no base rate rises until 2016.

Last month it emerged that the weakening outlook for inflation had persuaded MPC ‘hawks’ Ian McCafferty and Martin Weale to abandon the push for higher interest rates that they had been voting for since August. The change of heart came after the Bank’s official Consumer Prices Index (CPI) inflation benchmark slipped to an almost 15-year low of just 0.5 per cent in December.

The Bank believes there is a “roughly even” chance that CPI inflation will turn negative in the first half of 2015 as tumbling oil and food prices play havoc with the MPC’s forecasts, minutes of the committee’s January meeting showed.

Nick Dixon, investment director at Aegon UK, says: “The Bank of England is clearly in no hurry to increase interest rates, but sterling’s gains against the euro have presented a new and unexpected challenge to the monetary policy committee, which may even mean we see a rate cut in coming months.

“With near-zero inflation, a strengthening currency and muted wage growth, the question has suddenly become relevant and, as a number of European countries are now exhibiting negative rates, it’s not inconceivable that we see the dovish members of the committee now start to consider a 0.25 per cent rate as an option.”

Low interest rates have not been confined to the UK. Fund manager Sebastian Lyon of Troy Asset Management, writing in his January outlook, said: “Despite periodic forecasts of interest rate rises since 2010, rates around the world continue to go in the opposite direction. The Canadians, the Swiss and even the Singaporeans cut rates in January, and outside emerging markets it is impossible to find a return on cash above +2 per cent. We would not hold our breath for the Federal Reserve to hike rates. It may proved short-lived even if they do.”

Against this backdrop, investors’ search for yield has become increasingly desperate. Cash has not been the answer, with the Financial Conduct Authority recently highlighting that £160bn of the funds held in easy-access savings accounts earned an interest rate equal to or lower than the Bank of England base rate of 0.5 per cent in 2013. The rush to buy the market-beating rates on offer from NS&I 65+ Guaranteed Growth Bonds highlights the ongoing importance of a dependable income to investors. But with only £20,000 available per person, they are but a drop in the ocean for retired investors with substantial portfolios.

Traditional sources of income, such as government bonds, look unappealing. The 10-year gilt rate has fallen to a historic low of 1.4 per cent. This means that if you lent money to the UK government for 10 years, you would now get a return of just 1.4 per cent a year.

UK equity income funds, offering yields of 3-5 per cent, are an obvious port of call for income-starved investors and were the best-selling Investment Association (IA) fund sector for 2014, clocking up net retail sales of £6.3bn. Property funds also attracted heavy investment in an income-starved environment, according to IA statistics.

But many analysts are warning that the looming spectre of deflation could prove disastrous for equity markets. Peter Elston, global investment strategist at Seneca Investment Managers, says: “We are certainly set to remain in a low-inflation environment. And while I am still hopeful that the UK can avoid deflation, there is now the possibility of these headwinds pushing us into negative inflation territory. If those fears are realised, investors across all asset classes will need to reassess their portfolios. Equity investors have every reason to be afraid of deflation.”

He explains that, as prices fall, real interest rates rise and the real value of debt held by the private sector increases, while corporations see falling revenues as customers hold back spending in anticipation of cheaper prices later on.

Investors should be aware that cash is king in a deflationary world. While you may not earn much interest, cash gains in value as prices fall. Gold, which many investors consider an inflation hedge, can also be a useful deflation-fighting tool.

Pete Comley, the author of Inflation Matters, believes near-zero inflation is coming and has real implications for your wealth over the coming decades. You can read his article specially written for Investors Chronicle readers here.

So investors face some real asset allocation dilemmas. Andrew Wilson, head of investment at Towry, sums up the situation well. He says: “Cash and short-dated government bonds have proved near useless for anyone seeking a reasonable real return on their money, and so investing in financial markets and real assets has been an appropriate response, although requiring taking on more risk than the investors may have felt was ideal.

“This has worked well in recent years, but it is no longer so obvious that this is the way forward. Near all-time highs for bond markets, and equity markets that have come a long way without much improvement in corporate revenues, do not suggest that traditional portfolios have that much juice left in them. We are more likely in a much lower return world now, and one with substantially increased levels of volatility.”

We asked six analysts which funds they recommend for an environment of continuing low interest rates and near-zero inflation.

ADRIAN LOWCOCK, HEAD OF INVESTING AT AXA WEALTH

“Investors should be careful of reading too much into the drop in inflation as it is a temporary effect of the falling oil price. Equities tend to do well in mild inflationary environments as we have at present as companies are able to raise prices. Low interest rates and the prospect of deflation have driven bond yields to low levels and boosted the capital value or price of those bonds. The risk is that if inflation reappears, interest rates will rise and bond prices fall as yields also rise. A broad strategic bond fund would be best as this provides the manager with the greatest flexibility to invest in all areas of the bond market as they see fit.”

Recommendations

■ Threadneedle UK Equity Income (GB00B8169Q14) “Managers Leigh Harrison and Richard Colwell combine top-down, macroeconomic research with company analysis to create a concentrated portfolio of good-quality companies at attractive valuations,” says Mr Lowcock. The fund yields 4 per cent.

■ Artemis Strategic Bond (GB00BJT0KT28) “Manager James Foster focuses his analysis on interest rates, inflation expectations and bond quality to determine the make-up of the portfolio. Mr Foster has a lot of experience,” says Mr Lowcock. The fund yields 4.6 per cent.

MICK GILLIGAN, HEAD OF FUND RESEARCH AT KILLIK & CO

“If we have low interest rates for another couple of years then there’s a couple of areas that give better returns than cash – for example, short-dated bonds and asset-backed securities that give income linked to Libor. However, if we are in this deflationary environment for another five to 10 years then you need to buy long-dated government bonds or equities of companies with strong pricing power that can defend prices – for example, tobacco stocks and Nestlé – and companies with very little debt on their balance sheets. If we have a halfway house you need to be a bit more balanced.”

Recommendations

■ iShares £ Corporate Bond 1-5 Year UCITS ETF (IS15) is an exchange traded fund (ETF) and has a 2.7 per cent yield. It aims to track the performance of the MarkitiBoxx £ Corporates 1-5 Index, which offers exposure to sterling-denominated corporate bonds with an expected remaining time to maturity between one and five years. The index includes only investment-grade bonds with a minimum amount outstanding of £100m. The ETF invests in physical index securities.

■ PFS TwentyFour Monument Bond Fund (GB00B3XVTT21) aims to provide an attractive level of income relative to prevailing interest rates, while maintaining a strong focus on capital preservation. The fund’s investment focus is European and Australian residential mortgage-backed securities (RMBS), which must be rated at least BBB- or equivalent at the time of investment. It has a yield of 2.1 per cent.

■ Fundsmith Equity (GB00B4LPDJ14) aims to achieve long-term growth in value, investing in shares of companies on a global basis. “It holds companies with pricing power and little debt,” says Mr Gilligan.

■ Troy Trojan Fund (GB00B05KY352) and Personal Assets Trust (PNL) are both managed by Sebastian Lyon and “hold equities with strong pricing power and little debt, plus bonds and gold”. Personal Assets Trust is trading at a 1 per cent premium to its underlying net asset value.

RUSS MOULD, INVESTMENT DIRECTOR AT AJ BELL

“If stock-picking is not your game and you prefer a fund, in the knowledge the fees will erode some of the potential income benefits, the UK market offers plenty of choice. Lots of investment companies target income, although a lot of those with the best track records of fattest yields trade near asset value or even at a premium.”

Recommendations

■ Royal London UK Equity Income (GB00B3M9JJ78) seeks to achieve a combination of income and capital growth. It invests solely in high-yielding UK stocks, with a particular emphasis on companies generating significant free cash flow to fund sustainable dividend payments. It yields 3.6 per cent.

■ Brunner Investment Trust (BUT) aims to provide growth in capital value and dividends over the long term through investing in a portfolio of UK and international securities. Mr Mould says: “It’s not a dedicated income fund, but has grown its own dividend each year for more than 40 years and targets the sort of solid, cash-generative companies that have strong payout profiles of their own. The 14 per cent discount to net asset value (NAV) results from debts that mature in 2018 and 2022, but Brunner keeps cash aside and, as they mature, the discount could close.” The trust yields 1.9 per cent.

STEVE WILSON, ALAN STEEL ASSET MANAGEMENT

“Low interest rates have been a problem facing investors for some time now and, with the UK 10-year gilt yield at only 1.45 per cent, that doesn’t look too favourable, either. Even Italian bonds are only yielding 1.6 per cent and remember Italy was supposedly on the verge of collapse a few years ago. Property funds are again attracting investors’ money, but people need to be wary of liquidity as they found to their cost in 2008. That brings us back to equities and looking at good-quality equity income funds, both UK and global. Those funds invest in some of the world’s leading brand names that also pay good dividends. Those types of companies should be able to weather the storm regardless of economic conditions. Our favoured area over the past few years has been the US. While the market may well pull back in the short term, in the longer term we still think having a US bias will prove fruitful.”

Recommendations

■ Artemis US Equity (GB00BMMV4S07) aims to achieve long-term capital growth by investing principally in the shares of companies listed, quoted or traded in the US and is managed by Cormac Weldon. It has no yield.

■ Newton Global Higher Income (GB00B8BQG486) aims for increasing income and capital growth over the long term by investing in equities of companies located throughout the world and is managed by James Harries. Its yield is 3.6 per cent.

■ Rathbone Income (GB00B7FQLQ43) aims to achieve above-average and maintainable income without neglecting capital security and growth. Fund manager Carl Stick intends to achieve this objective primarily through the purchase of ordinary shares with an above-average yield. There is no restriction on the economic sectors or geographic areas in which the fund may invest. The fund yields 3.4 per cent.

TIM COCKERILL, INVESTMENT DIRECTOR ROWAN DARTINGTON

“Inflation has been coming down for some time now, but the push from oil price falls has brought it to our attention. It’s making quite a big difference in terms of fuel prices and has put more money in people’s pockets here and in the US than anything QE has ever done. For investors, equities are still one of the best things you can buy. A company that is profitable should increase its dividend payment. Equity income and global equity income funds are not a bad place to put your money. But for income funds you should look at the rate of income growth versus inflation to see if that is real. Your income will actually increase as inflation falls.

“In the short term (over the next six months) bonds are probably going to be quite reasonable. We’ll see modest capital gains on them. The ECB is buying up a lot of bonds. But it will be relatively short term. Yields will rise at some point.”

Recommendations

■ Perpetual Income & Growth Investment Trust (PLI) is run by Mark Barnett, has a 3.3 per cent yield and is trading at a 3 per cent discount. It aims to provide capital growth and real growth in dividends over the medium to longer term in the UK equity and fixed-interest markets. Mr Barnett also runs open-ended fund Invesco Perpetual UK Strategic Income Fund (GB00B8N46Y01), yielding 3.2 per cent. “Both of these funds are very suitable,” says Mr Cockerill.

■ Threadneedle UK Equity Alpha Income (GB00B88P6D76), yielding 4.1 per cent, is managed by Leigh Harrison. This fund aims to achieve a reasonable and growing income with the prospects of capital growth from a concentrated portfolio of UK equities.

■ Newton Global Higher Income (GB00B8BQG486) focuses on sustainable dividends reinforced by strict yield discipline and demonstrates resilience in difficult market conditions. It is a IC Top 100 Fund and its yield is 3.6 per cent. “Newton is quite conservative in the way it runs things,” says Mr Cockerill.

■ Murray International Trust (MYI) aims to achieve income and capital growth through investments predominantly in worldwide equities and has a 4.7 per cent yield. “It is trading at a premium [5 per cent] which I like to try to avoid, but the premium is less than it has been in the past. It’s the biggest trust in the sector and nice and liquid. Sometimes it’s good to be boring,” says Mr Cockerill.

■ BlackRock Smaller Companies Trust (BRSC) is managed by Mike Prentis and aims to achieve long-term capital growth for shareholders through investment mainly in smaller UK quoted companies. It has a modest yield of 1.7 per cent. “It may well in five years’ time from an income point of view be throwing off a lot of money,” says Mr Cockerill.

“It had 20 per cent underlying dividend growth last year and 19 per cent the year before. If it can maintain anything in that region, it will be quite impressive. It’s an interesting option if you don’t actually need income now.”

GINA MILLER, FOUNDING PARTNER AT SCM DIRECT

“With current interest rates and inflation set at very low levels for years to come, it would seem sensible to have a well-spread portfolio of low-cost ETFs from around the world investing in a mix of bonds and equities.

“For our SCM Direct discretionary portfolios we favour a longer, more diversified list of ETFs and to be more opportune. For more direct investors we have put together the selection in the table below for a simpler buy-and-hold strategy.”

A simple buy-and-hold strategy

Shares for income

For those happy to take a more hands-on approach to generating income, equities are a good option; according to the stock screening tool on our website 292 companies quoted on the London Stock Exchange currently offer a yield in excess of the newly launched pensioner bonds’ 4 per cent three-year rate, and 498 in excess of its 2.8 per cent one-year rate. A total of 573 shares yield more than 2.4 per cent, the best cash Isa rate currently on the market (a five-year fix). And 737 do better than the slightly above-average 1.7 per cent on a more flexible one-year cash Isa, as currently offered by newly floated Virgin Money. That’s roughly the same level that its shares will yield, based on the current share price of 300p and a forecast dividend payment for 2015 of 4.53p a share. That payment is expected to rise to 6.35p a share in 2016, which would mean a yield of 2.2 per cent.

That highlights an important consideration to be taken into account when investing in equities for income: the prospects for dividend growth. Some fund managers believe, in fact, that these are more important than the headline yield alone. Virgin plans to follow a “progressive” dividend policy, whereby it increases dividends in line with earnings at a fixed payout ratio. That ratio will start at between 10 and 20 per cent of post-tax earnings, rising as the bank matures. HSBC’s payout level is around 40-60 per cent, for comparison.

And income investors should never be tempted by a high yield alone. As with anything in life, if a dividend payment looks too good to be true, it probably is: unusually high dividends can often mean the dividend is about to be cut or passed altogether. So it’s important to understand whether a company is generating enough profit, and distributable cash, to be able to at least sustain its dividend payments, and that its debt obligations won’t require cash to be diverted towards paying off its loans, either.

One way to assess whether a dividend is safe is dividend cover. This is calculated by dividing underlying earnings per share by the dividend – and the bigger the result by the better. Anything north of 1.5 times is considered safe; anything below 1.0 begs questions over how the dividend will be funded in future years. High cover can also reveal companies that could distribute more dividends to shareholders, and we’re always on the lookout for companies that are generating more cash than they can invest efficiently – the housebuilding sector being a recent case in point.

Equity dividends are, of course, a higher-risk investment than cash – because there is a risk that dividend payments will stop or the underlying capital value of the investment will fall if the company runs into trouble. Bank shares were once seen as a safe haven for income seekers, before the great crash decimated the sector in 2008. So a good general rule of thumb for income seekers to follow – in all asset classes, and not just equities – is that the higher the potential returns, the higher the risk.

Of course, sometimes a bumper dividend is offered by mature companies as a substitute for potential capital growth – in short the dividend is, in theory, the sum total of the returns you can expect. However, a healthy dividend does not necessarily preclude capital growth – some companies are strong enough to continue generating excess cash even while reinvesting in business growth. Sometimes investors bid up the price of good dividend-paying shares because there is a paucity of income to be found elsewhere, and because such shares are seen as safe havens when the economic backdrop is uncertain.

Here we’ve picked a selection of our favourite dividend shares that demonstrate a range of these characteristics. JH