Wednesday 15 June 2011

How to Invest £21,360 for Income? (UK)

As part of the DIY Income Investor approach, every year you will have the opportunity to invest a new chunk of money in your tax-exempt account (Stocks & Shares ISA in the UK). If you are married, you potentially have two sets of allowance to invest - that is, if you have saved hard over the previous year (most of you will have spotted that the amount in the title is twice the current ISA allowance of £10,680).

So, how best to invest this annual lump sum?

Well, not surprisingly, it all depends on your personal situation and your tolerance for risk. It is a balance between risk and return - but preferably with a big safety margin.

The Income Pyramid

The starting point should be to look at the DIY Income Investor Income Pyramid. The basic principle behind this is that you develop your income-producing portfolio step-by-step, starting from safe cash and only investing in (slightly) more risky asset classes when you have built up an emergency fund and got some 'safe' investments under your belt. So, clearly, what you buy this year will depend on where you got to up the pyramid last year.

For people who are just starting out, you will still be building up your portfolio. The lower levels of the Income Pyramid are cash, cash bonds and some specific ETFs (discussed here).

However, if your portfolio is more mature, the options suggested by the Income Pyramid are:
  • government bonds (gilts)
  • high-yield shares
  • corporate bonds  

Do You Need to Re-balance Your Portfolio?

A further issue may be the need to re-balance your portfolio - this is on of the great benefits of income investing: you regularly get to buy new stuff, and so you have the opportunity to re-balance your portfolio.

Now, a lot has been written about the right portfolio composition. A reasonably rule-of-thumb is that  the percentage of fixed-interest investments should be similar to your age (i.e. at 50, 50% of your portfolio should be gilts, bonds, cash bonds, etc.). The problem with this is that people usually own quite a few other assets - for example, they may have a company pension and equity in property, such as the family home. So self-invested financial assets (i.e. separate from your company pension) might only account for 25% of your total assets, so it is maybe not sensible to be too precise about this split between cash, equity and fixed-income. The main issue is to have enough liquid assets to deal with a major emergency, so that you don't have to sell in a market downturn.

Anyway, my own self-invested portfolio is still over 70% cash and bonds/gilts - so quite conservative by the 'rule-of-thumb' measure. With that in mind, my main objective is to find something with a high (and hopefully sustainable) yield - I can accept some level of risk.

The Options

The choices available (and discussed previously in this blog) seem to be:
  • perpetual gilts: the highest-yielding gilts are perpetual Consolidated 4% (CN4)  - current (mid-June 2011) gross income (and redemption) yield (according to Bondscape) of 4.8% 
  • high yield shares: with most of the 'safer' top yielders at around 5% - see a summary of the FTSE 100 here
  • perpetual corporate bonds: these are offered by several banks e.g. HSBC, Standard Chartered, Barclays - current yields around 7-7.5%, , e.g. my recent Standard Chartered purchase, currently with a 7.58% income yield
  • building society pibs (permanent interest-bearing shares): yield around 7% (discussed here): yield around 7.5%

In addition, with a lump sum like this, some of the other - non-perpetual corporate bonds become accessible. They often must be traded in minimum quantities of 10,000 or more. ISA rules mean that the bond must have at least 5 years until maturity - so this limits the search to maturity dates beyond 2016. Given that I will probably be holding to maturity, it is the yield to maturity (ytm), rather than the income yield (iy)that is important.

There are lots of potential targets with reasonably attractive yields - the difficulty is judging their risk profiles. Probably the safest approach is to discount the very high yielders.

A selection of 'possibles' might include:
  • BT 2016: iy 7.19%, but ytm only 4.18%
  • Co-operative Bank 2017: iy 5.18%, ytm 5.34% 
  • Enterprise Inns 2018: iy 7.38%, ytm 8.7%
  • Provident Financial 2020: iy 6.78%, ytm 6.51%
  • Aviva 2026: iy 6.58%, ytm 6.74%

The Enterprise Inns bond (2018, 6.5%, EE18) has the highest yield - but there have been some question question marks about loan covenants in the past. TD Waterhouse carried an article about this security last year, noting that it is 'non-investment grade' BB+ and recognising its inherent riskyness. An article in Investor's Chronicle noted in relation to this security that:

It is always tempting to look through a list of bonds and select the highest yielding member. As a method of selecting assets, I would not recommend this – you'll just end up with a portfolio of high-risk bonds. Nevertheless, a few high-yielders can liven up a safe-but-dull portfolio, and such a role could be fulfilled by this issue. (...) It is worth noting that the bond is a debenture, with the assets secured against a portfolio of 503 pubs. So with the benefit of at least some kind of hold on the underlying assets, and a yield of nearly 10 per cent, the Enterprise Inns 6.5% 2018 makes for a tempting prospect for risk-positive investors.

If you check out the covenants on this bond issue in the 'deed of trust' (which is a senior secured bond) they are most definately reassuring, as follows: property (valued at fair value as opposed to going concern) is ring-fenced in a special vehicle that must equal 1 and 2/3rds of the total value of the bond issue (at issue 225millions) + 2 years worth of coupon. This property is revalued regularly when more property is added / removed from the vehicle as appropriate.

So, there it is - potential yields from around 5% to around 10%, with risk running from 'safe as the Bank of England' to 'risky' - which would you choose?

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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