Interest rates are low, where can we go?

Tuesday, 16th August 2016 09:55 - by David Harbage

Since Bank (often termed base) rate was lowered from 0.5%, that has prevailed since 2009, to 0.25% on 4 August - and the Bank of England’s Monetary Policy Committee has warned that overnight interest rates could fall to zero – savers and investors alike have been reassessing where to place their hard earned cash.

They face the prospect of flat domestic economic growth (GDP of circa 0.5% - 1.0%) over the next two years, as UK consumers wait to see if the consequences of Brexit turn out to be as bad as the ‘learned opinion’ had predicted before the referendum. This could well deliver a ‘self-fulfilling prophecy’ amidst unimpressive economic growth in most of the world’s major developed nations. Public sector finances are likely to come under pressure as tax receipts (from VAT and corporation tax in particular) fall short and HM Government has to raise more monies to compensate.

 A satisfactory answer to one of the questions most often asked by retired people: “Where can one obtain a decent rate of interest?” has become even more elusive. The uncertain economic outlook, not helped by considerable political upheaval at home and rising terrorist or geo-political concerns overseas, has persuaded many institutions and private investors to buy the classic ‘risk-free’ investment of fixed interest bonds which are backed by HM Government. Demand for medium and long dated ‘gilts’ is such that their price has risen dramatically and consequently yield (or interest rate offered) has fallen to reflect an interest of just over 1% on long dated issues. The Treasury has taken advantage of this opportunity to tap the market - essentially borrow more cash to meet the shortfall in public finances – at what is effectively a negative real (so termed when inflation is higher than the cost of borrowing or the) interest rate. So if earning about 1% over the next ten years does not appeal, inflation-linked gilts might offer a more rewarding, if less certain, return. Weaker sterling means that Britain’s imports – be they motor cars or food – will cost more, so domestic inflation is likely to rise and (irrespective of the hike in the so-called ‘living’ wage) depress living standards.

 Incidentally, the prospect of several leading countries (this is not limited to the UK) stimulating economic activity by reducing interest rates and introducing other measures (notably buying government or corporate bonds to reduce longer term rates) often termed ‘quantitative easing’ - whereby the supply of money is increased – has prompted a revival in appetite for gold, despite a lack of income return from the supply-constrained precious metal. The commodity’s ‘safe haven’ status traditionally has been driven by fears of currency devaluation (caused by ‘printing’ or other engineered increase in stock), especially any whiff of US dollar weakness, or at times of war or rising geo-political tension. Bottom line, an investor or trader in gold (as opposed to company shares in gold mining extractors) is solely making a judgement on the price of the asset in the absence of any income return.

 An investment in premium savings bonds might appeal to speculative savers, offering as they do an interesting, debateable mix of ‘pros and cons’. The prospect of winning an income tax-free ‘prize’ could be viewed as exciting, but such ‘income’ is not guaranteed (the odds of winning each week are 30,000 to 1). The total prize ‘pot’ equates to a somewhat underwhelming (lower than forecast inflation) interest rate of 1.25% - which can be varied at any time, and is probably set to fall; someone ‘investing’ the maximum £50,000 would expect to receive at least one prize (which could vary between £25 and £1,000,000).        

 For investors prepared to take a longer term view of their savings and are more concerned about the level of income they will earn on their assets, rather than the current value, could look at higher dividend paying company shares. However, with the capital worth fluctuating on a near-daily basis, such investment is not for the faint hearted. This turbulence or risk can be mitigated by having exposure to a broad spread of businesses – across different sectors of industry and commerce, as well as incorporating most of the world’s leading economies – and extending the period of time that such equity investment is retained. Subject to being comfortable with the nature of the asset and its risk-reward profile, higher yielding company shares could represent a partial solution to the dearth of income offered by other, more traditional ‘homes’ for cash savings. Individuals possessing or considering tax-free shelters – such as an Individual Savings Account (ISA) and the Self-Invested Personal Pension (SIPP) - or other account, might wish to investigate the following stocks.

 Unless specifically stated to the contrary, each of the following company shares are industry leaders, offer dividend income returns that are covered by profits and benefit from their revenue arising in many countries:

1. Royal Dutch Shell – the shares of this fully integrated (up and downstream operations) international oil & gas major, and largest company in the FTSE100 index, currently yield 7.2%. While profits this year (and, to a lesser extent, next) are expected to be restrained by the low oil price, a marked recovery is anticipated in 2017 and the consensus of broker forecasts does not expect the £ dividend to be cut.
2. HSBC - the shares of this global bank and second largest company in the FTSE100 currently yield 7.2%. While profits this year are expected to be restrained by regulatory fines and PPI claims, earnings are expected to bounce back in 2017 and the consensus of broker forecasts does not expect the dividend (in £ terms) to be cut.
3. British American Tobacco - the shares of the second largest cigarette producer in the world, and the third largest company in the FTSE100 index, currently yield 3.1%. While this is slightly below the average for the UK equity market, double digit profit growth this year and next should maintain an impressive dividend track record and extend the cover to 1.5 times, with the anticipated pay-out in 2017 worth 3.5%.
4. GlaxoSmithKline - the shares of one of the world’s largest pharmaceutical companies, and the fourth largest constituent within the FTSE100 index, currently yield 4.7%. Double digit profit growth this year and further progress in 2017 should extend the dividend cover to 1.25 times the anticipated pay-out.
5. Vodafone - the shares of one of the world’s largest mobile telephone groups, and the seventh largest company in the FTSE100 index, currently yield 4.8%. Following the disposal of its valuable stake in US operator Verizon, the dividend is not covered by earnings. However, with double digit profit growth this year and next, no cut in the dividend is anticipated.
6. Diageo - the shares of one of the world’s largest spirits maker and brewer in the world, and the eighth largest company in the FTSE100 index, currently yield 2.6%. Whilst this is below average for the FTSE100, inflation-beating earnings growth in the year ended 30 June 2016, but more particularly in the next, should maintain the company’s progressive dividend and extend cover to 1.7 times, with the anticipated pay-out in 2017 worth 2.9%.

 Beyond those multinational mega cap businesses whose equity worth exceeds £55 billion in every case, the following six companies represent high dividend payers but feature domestic as well as geographically-diverse and also significantly smaller market capitalisation – and as such could be perceived as a little higher risk-reward:

1. Aberdeen Asset Management - the shares of this £4.4bn international investment management (FTSE100 index constituent) group currently yield 5.9%. Despite the prospect of a bumpy ride for earnings over the next two years to 30 September 2017, the barely covered dividend is expected to be maintained. Sentiment would benefit from a pick-up in the worth of its assets under management (AUM). 
2. Scottish & Southern Energy - the shares of this £15.6bn (FTSE100 constituent), and the UK’s third largest supplier of electricity & gas group, currently yield 5.8%. Regulated profit and dividend growth in the next two years to 31 March 2018 is expected to match domestic inflation; the pay-out is covered 1.25 times by earnings.
3. TalkTalk Telecom Group - the shares of this £2.2bn (FTSE250 index constituent) voice & broadband operator for domestic consumers and businesses currently yield 6.9%. Although this dividend pay-out was not covered, strong double digit profit growth in the next two years to 31 March 2018 will rebuild cover to 1.1 times earnings. No cut in the dividend is anticipated for this perennial bid candidate.
4. Carillion - the shares of this £1.24bn (FTSE250 constituent), UK-oriented construction services group, currently yield 6.3%. Profit and dividend growth in the next two years to 31 December 2017 is expected to grow in-line with domestic inflation; the pay-out is covered 1.9 times by earnings. A beneficiary of public & private sector outsourcing.
5. Pearson - the shares of this £7.4bn international education-focused publishing house (FTSE100 index constituent) group currently yield 5.8%. Despite the prospect of a bumpy ride for earnings over the next two calendar years, the dividend is expected to be maintained and cover could reach 1.25 times by the end of 2017.
6. Royal Mail - the shares of this £5.2bn (FTSE100 constituent), and the leading provider of postal & delivery services in the UK, currently yield 4.3%. Profit and dividend growth in the next two years to 31 March 2018 is expected to be in-line with domestic inflation; the yield rising to 4.7%, pay-out covered 1.75 times by earnings.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.