Investors have a growing need for income but the biggest question they face is how this should be generated in the current environment.
Many people would traditionally leave their money in a deposit account and take the interest on either a monthly or annual basis however savings rates are so low that even fixed rate bonds may not be able to offer enough for those that are looking for income. With interest rates remaining at historic lows and no real prospect of an imminent rise, the search for the most appropriate solution is being widened with many individuals and their financial advisers considering a range of other income generating investment products, such as corporate bonds, distribution funds and equity income portfolios.
An increasing number are also turning to the structured products market - and I would argue, not without good reason. With a variety of different strategies in place, many structured income plans could help deliver the ideal combination of risk and return with which an individual may be comfortable. Many of the strategies mentioned above can be useful when looking for real or natural income however structured income plans should certainly never be ignored. They can not only deliver competitive, and in some instances tax efficient coupons using a wide range of pay-off profiles, but do so while aiming to protect capital as well. In any environment, that could be an attractive combination.
Having said that, those of us with long memories and a wider perspective on investment markets are fully aware that there is no such thing as a totally free lunch and in times of low interest rates and higher than average volatility, investors need to accept that the pursuit of a potentially higher level of income may cost them more in the shape of increased capital risk. Over the past year or so it has become increasingly difficult for clients to generate returns in excess of the average cash deposit account so taking on an element of capital risk may now unfortunately be a necessary evil. So what is the starting point? What do advisers and their clients need to consider before seeing what's available in the market?
When any client starts searching for the most appropriate income strategy yes it's important to establish how much they need and then look to see which products are most appropriate however, first and foremost the initial question needs to centre on how much risk they are prepared to take. Sadly, that's not always the case with many clients invariably getting hooked in by the potential higher level of income on offer and ending up taking on more risk with their capital than they originally would have liked; need I mention again the precipice bond scandal of the late 90's?
Such problems can easily be avoided by accepting their capital may be at risk with the trade off being the prospect of a much higher level of income. That is where the adviser's fact find should focus its attention - and as early as possible in the process. Then the solution is made easier by fully understanding how much income can be delivered for a given level of risk.
Traditionally, many advisers and clients would use a Life Assurance Bond to generate a 'tax deferred‘ income with advisers building a suitable portfolio of investment funds within the bond and then selecting up to a 5% 'income‘ facility. However the main problem with this strategy is that units need to be encashed to provide the income which means, in many cases, that the original capital may be eroded in an untimely manner as the income is not natural. Many distribution funds meanwhile, owing to their asset allocation, do provide a natural income but not true capital protection given the sometimes high equity content within the fund. Equity income funds speak for themselves however once again the risk strategy would tend to be high when compared to the income levels on offer and then you have the various structured income products available in the market.
The first port of call is structured deposits in which the capital may be completely protected so it doesn't matter what happens to the underlying asset class, say the FTSE 100 index. As an added safety net, structured deposits are also protected by the Financial Services Compensation Scheme up to £50,000 for eligible claimants. The downside, however, is that the income levels are not hugely attractive at present. Income plans can also be structured using medium term notes (these are sometimes referred to as reverse convertibles), where capital is at risk if the FTSE 100 more than halves throughout the investment term but that potentially provides a higher level of income in return for the increased level of risk. Currently with volatility levels where they are, clients prepared to take on an element of market risk are being reasonably well rewarded in terms of increased income levels. For example, while a structured deposit may hypothetically pay around 4%, a structured note may pay around 7% and more often than not, in a more tax efficient way. This simply could not be done with a traditional equity income fund or corporate bond fund.
Having said all that I do not believe that structured income plans are the panacea or that one income generating asset is always going to be better than the others because it always depends on the individual's circumstances and propensity for risk. Equity income funds for example may look attractive when higher dividend rates are available, while corporate bonds may look attractive in higher interest rate environments. It's all about striking the right balance. If the economic backdrop remains the same with interest rates going nowhere and volatility rising, as I suspect it will, and combined with the fact that the population demographics are also changing with more and more people retiring early and looking for additional income, then clients may have even more need for income.
Moving forward it is important that clients and their advisers must not think of structured income plans as high risk because that is simply not always the case. These plans use derivatives efficiently to potentially increase income without necessarily adding substantial risks to a client's capital. Advisers and clients are increasingly seeing that these plans are not the old precipice bonds that they once were, they are sensible, efficient products that could generate income while maintaining an element of protection. The message is clear, advisers and clients need to understand how much risk they are prepared to take and then choose which product best fits the bill; start with the risk and then focus on the income strategy.
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