UK: Producing A Real Return In An Uncertain World

Last Updated: 9 February 2012
Article by Ian Richley

What should your charity's investment strategy be in the current unusual economic environment? Ian Richley discusses.

Developed economies are likely to remain overshadowed by structural challenges for many years, principally due to demographic trends and excessive sovereign debt, problems that have been looming for a decade but are only now beginning to force changes in living standards.

This economic malaise poses a huge challenge for charities. Despite an inflation rate which has been above the Bank of England (BoE) target rate of 2% for 24 consecutive months and is currently only modestly lower than that of China, interest rates in the UK have been anchored at their lowest ever rate of 0.5% for more than two and a half years and there is little reason to believe that rates will increase any time soon. On the contrary, the BoE recently embarked on a third round of 'printing money' via quantitative easing (QE).

Against such a backdrop, there have rarely been greater headwinds faced by charities aiming to generate income from their assets while maintaining their real value.

The hope is that QE and a period of unusually low interest rates will provide sufficient support to offset the impact of deleveraging, which threatens to push economies back into a more prolonged recession if left unchecked. The effectiveness of QE is difficult to measure. Although it has probably served to prevent an even greater economic downturn in the short term, the long-term ramifications are more worrisome. Indeed, its primary rationale is to provide banks with liquidity and to underpin asset prices. In other words, savers are being encouraged to borrow and investors to speculate in a bid to maintain the purchasing power of their money. The risk is that the current approach being adopted by the BoE could eventually lead to a period of heightened inflation.

So, which assets are likely beneficiaries of this unusual economic environment? Which offer the scope for maintaining their real value while providing the above average level of income typically sought by charities?

Index-linked bonds

Investments that offer the same real return regardless of the rate of inflation are likely to remain in favour with investors. The future returns generated from UK government index-linked bonds are linked to the Retail Price Index (RPI), which is arguably a better reflection of true inflation in the UK than the more commonly cited Consumer Price Index (CPI). Furthermore, RPI has historically risen faster than CPI and there is good reason to believe that this trend will continue. The first UK government index-linked bond was issued in 1981; the market has since grown to represent 20% of total UK government bonds in issue. They are highly liquid and often find particular favour with investors during periods when riskier asset classes, such as equities, are struggling to perform, therefore providing diversification benefits.

Those investors able to tolerate greater risk may consider inflation-linked corporate bonds. While this market is typically less liquid than that of government bonds, the potential returns are generally more attractive to compensate the investor for the higher credit risk. This market is still in its infancy, with a total value of just over £10bn and fewer than 300 sterling issues. Typically they are issued by household names, such as Tesco, or utility companies that benefit from relatively predictable and often inflation-linked earnings streams.

Shares in large multi-national companies

In the current low interest rate environment, large multi-national companies with robust balance sheets and globally recognised brands are typically at a significant advantage over smaller businesses due to their access to capital markets. Such companies can issue debt through the corporate bond market at very low rates of interest, such is the demand from income-starved investors.

A good example is Coca-Cola, one of the most recognised brands in the world. The group pays an average of only 3.8% on current debt and this rate should decline as debt matures and is refinanced. Indeed, it can effectively borrow new money at a little over 1% if this is achieved through the issue of short-dated bonds. Coca- Cola now generates 75% of sales outside North America and its turnover in BRIC (Brazil, Russia, India and China) countries is growing by more than 25% per annum. It is taking advantage of low interest rates to invest more in countries such as India, where the group recently announced its intention to invest $2bn over the next five years. Coca-Cola shares currently offer a dividend yield of 2.9%.

There are many other shares that have similar characteristics to Coca-Cola, which offer investors reasonable dividend yields and scope for positive real returns.

Emerging markets

The IMF recently predicted that by 2030 the Chinese economy will be of a similar size to the US and EU economies combined. Clearly, such long-term forecasts are prone to error but they are indicative of the acceleration in the shift of global power from West to East which is now underway. Historically, UK charities have typically gained exposure to emerging economies indirectly, through shares in companies listed in the West that operate in those economies. This approach certainly has merit, not least as many such shares are relatively stable and offer attractive dividend yields.

However, this can be complemented by investing through collective vehicles that invest directly in emerging markets, focusing upon higher yielding and defensive sectors such as utilities and telecommunications. These markets have evolved enormously since the Asian crisis of the late 1990s and management have become more aware of the need to provide investors with steadily rising dividends. In 1995 there were just 75 emerging market listed stocks that offered an income yield in excess of 3%; by 2010 this had risen to 205. Indeed, of the approximately 800 companies currently listed in the MSCI Emerging Market Index, over 25% offer income yields of over 4%. Furthermore, the average company listed in emerging markets is less indebted and pays out less of its overall profit in dividends, indicating reasonable scope for dividends to rise.

Maintaining a balanced portfolio

Index-linked bonds, shares in multinational companies that have good access to capital markets, and collectives that offer exposure to higher yielding shares in emerging markets are examples of investments that offer reasonable sources of income for investors looking to maintain the real value of their assets in the current unusual economic environment. Nevertheless, these investments should not be viewed in isolation but rather in the context of a reasonably balanced and diversified portfolio that is appropriately positioned to reflect the charity's specific circumstances, objectives and tolerance for risk.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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