Returns come in three flavours: 3 Income plus Lump Sum
Bonds are a form of financial asset that typically provide an income stream and the promise of redemption at some date in the future. Most Government Bonds (gilts) are in this category, and you can have a good deal of confidence that you will receive exactly what has been promised both in terms of the income and the lump sum on redemption, since both are guaranteed. Bonds are also issued by local authorities and companies. These do not carry the same degree of certainty that the promised payments will be made. Local authorities have been known to default, although not very often, and companies can and do go bust. But if you hold a bond to maturity (redemption) then both the income and the lump sum terminal payment are under the control of whoever issued the bond. No part of your return depends on you having to sell them.
How much is the income worth?
Real and financial assets that provide an income stream (or the hope of one), whether or not they can be redeemed, obviously have a value because of the actual or expected income. However, the value that another investor (or the market) will place on an income stream will depend on several factors. It is important to realise that it is what the market expects will happen to factors such as interest rates, and inflation, and economic growth, that determines the price that it will put on an asset that provides an income stream, and these expectations are changing all the time. The more uncertainty there is about these expectations the greater the fluctuation in prices, which is why the prices of shares can be so volatile.
Effect of markets
It is important to realise that the returns on investments that provide an income stream but no prospect of redemption (equities, undated bonds, property) are subject to two quite different risks. Firstly, there is the risk to the income stream. In the case of equities, properties, and some types of bond the stream might be reduced to a trickle or even dry up altogether. However, if you spread the risk between a large enough number of individual investments the chances of the income drying up completely are fairly small. Secondly, there is the risk you take by having to sell your investments into a fickle market if you are counting on getting the cash.
The reason why equities are regarded as high risk is because in the short-term, the day to day movements in share prices often dwarf the income you are likely to receive in the first year or so. However, the longer you hold them the more your return depends on the income stream from the dividends rather than the cash you would get from selling the shares. Since dividends are much more stable than share prices, the risk of holding shares falls as the length of time you hold them increases.
If you could have put £100 into a share index-tracking fund in 1899 it would have returned you £19,671 in real terms by the end of 2001. But by far the greatest part of that would have come from reinvesting the dividends. The value of the shares would only have increased to £195 in real terms (figures from Barclays Capital Equity-Gilt Study 2002). If you had bought shares at the top of the market just before the Great Crash in 1929 it would have been 1952 before your shares were worth in real terms what you had paid for them. However, over that time you would still have made twice as much (in real terms again) through receiving dividends as you would by investing in Government Bonds, and three times as much as you would by keeping it in the bank.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|