On the income hunt once more

David Prosser explores how investment companies can offer income opportunities as inflation falls

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Here we go again. While the latest fall in UK inflation is to be welcomed, financial markets are already pricing in interest rate reductions for 2024. Those would be good news for mortgage holders, of course, but the fact there are many more savers than borrowers in the UK is often overlooked. Savings account rates now look set to take a hit.

Indeed, banks and building societies are already cutting the rates they pay. Today, the best deal on a one-year fixed-rate savings account pays annual interest of around 5.1%; a month ago, it was 5.4%. The pace at which rates have come down in recent weeks has been faster than at any time for a decade, according to personal finance provider Moneyfacts. Moreover, while 5% still seems generous compared to recent years, when interest rates have been at rock-bottom levels, it’s pretty mediocre by long-term standards.

All of which means that if you’re looking to your savings and investments to generate income, next year could be challenging. You may well need to look beyond risk-free options such as cash savings accounts. And the traditional next step for income seekers – the bond market – isn’t alluring either; bond yields are closely linked to interest rate expectations, so they have fallen sharply too.

In which case, income-focused investment companies are once again going to stand out. During the years following the financial crisis and then again in the Covid-19 pandemic, as interest rates hit lows that would once have seemed inconceivable, these funds were hugely in demand. Their shares often traded at a premium to the value of their underlying assets. More recently, most funds have slipped to discounts, as their income potential has felt less important, but we are once again heading towards a shift in the market landscape.

It's important to recognise that even investment companies with a clear income-oriented objective may not always offer huge yields upfront. The average UK Equity Income fund, for example, currently yields a little over 4%, though there are several investment companies in this sector offering 6% or more.

“A diversified portfolio of holdings, designed with your income needs in mind, could be a smart way to overcome falling cash returns next year.”

David Prosser

David Prosser

However, you’re getting two other benefits with these funds. First, they often deliver a rising income, increasing their dividend payouts over time. And second, there is the opportunity for capital gains too, particularly over longer periods.

On the first of these benefits, investment companies have real advantages. Most importantly, they are entitled to hold back some of the income their portfolios earn in good years in order to subsidise distributions to investors in leaner times. This is how the AIC’s “dividend heroes” – a group of funds raising dividends every year for at least 20 years – have been able to offer rising income through thick and thin. Also, investment companies can pay income out of capital, assuming the board has a mandate from shareholders to do so.

As for the second investment company benefit – the potential for capital gains – you need to recognise that this comes with the possibility that your stake could fall in value rather than rise. However, if you’re prepared to invest over an extended period – more than five years, say – the historical track record of investment companies bodes well for future growth. And in the meantime, you’re entitled to keep receiving all that income.

Finally, note that you don’t have to stick to the UK stock market in the hunt for income. The AIC’s dividend heroes include plenty of UK-focused funds, but also several that invest internationally, as well as some that give exposure to other asset classes. A diversified portfolio of holdings, designed with your income needs in mind, could be a smart way to overcome falling cash returns next year.