Gaining interest

Are we finally about to see interest rates rise again? After more than a decade of rates at record lows, rising inflation and economic growth figures that are just about holding up could prompt the Bank of England to raise interest rates for the first time since July 2007 – possibly as soon as at November’s meeting of the Monetary Policy Committee.

A move towards higher rates will be welcomed by many savers, who have suffered consistently during this period of loose monetary policy. The average easy access bank and building savings account currently pays an annual interest rate of just 0.34 per cent according to the personal finance data provider Moneyfacts.

But there’s no point in getting too excited. The first rate rise, when it does come, will be no more than 0.25 percentage points, worth just £2.50 for each £1,000 of savings you hold, even assuming banks and building societies pass it on. And the Bank has made it clear that subsequent rises will be both small and gradual.

Meanwhile, the investment company industry continues to offer much more generous rates of income to those who are prepared to accept at least some downside risk to their starting capital. No fewer than 13 investment company sectors currently offer a yield of more than 3 per cent a year according to analysis from the Association of Investment Companies.

Closed-ended funds have certain structural advantages that underpin these generous yields. They are able to operate with dividend reserve funds, keeping back some income in good years to subsidise pay-outs during periods of slimmer pickings. They can also finance income payments from capital if shareholders give them the permission to do so.

Even if interest rates do move onto an upwards trend, it seems likely therefore that investment companies will remain an important element of many income-seeking investors’ portfolios.

All the more so given the potential diversification benefits that closed-ended funds offer. Higher interest rates are typically associated with less attractive stock market returns, since they reduce the amount of money in people’s pockets and therefore inhibit their spending power. That’s problematic for investors with exposure to equities, including those who have bought into equity income funds in search of more yield.

Significantly, however, four out of the top five yielding sectors highlighted in the AIC’s research are not equity-focused. Leasing funds offering a yield of 6.9 per cent, debt funds offering 6.5 per cent, renewable energy funds offering 5.7 per cent and infrastructure funds offering 4.8 per cent all provide potential diversification for investors who are also holding UK equity and bond income funds, which currently yield 5.2 per cent.

These sectors carry risks of their own, but the underlying assets in such funds will all respond to interest rate increases in different ways. That’s exactly the breadth of exposure that investors need during periods of market volatility.

We will have to wait and see to find out whether the Bank really does take the plunge on interest rates in the coming months; and the exact impact on specific asset classes is difficult to predict, with so many different factors coming into play. Nevertheless, investors who have flooded to the investment company sector in search of both yield and diversification in recent years will have every reason to stay put even if rates do start rising. And many other investors may still be tempted to join them.