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Income risk

Unless we are talking about a redeemable investment that we intend to hold to maturity, income return and lump sum return come from quite different sources and are subject to different risks. Let’s look first at income return and risk.

Income stream returns

Investments that produce income returns fall into three main asset classes: fixed interest (bonds), property, and equities (shares). What we are concerned about here is what risks there are to that income. Let’s take them in order.

Bonds

If you hold bonds issued by the central government of a stable country you can be pretty sure of getting the income you expect. After all, governments issue the currencies that you are being paid in and they can always print some more. Even when the economy of a country is in a pretty desperate state, it would be extremely unlikely for a government to default on bond payments. What is much more likely is that a struggling economy will see the value of its currency fall against other international currencies causing inflation at home and a loss of spending power abroad. So whilst the income from government bonds is very safe in money terms, it is less safe in real terms. But that applies to other bonds too.

Bonds issued by companies and local authorities carry more risk, and because of that offer higher interest rates (coupons). There is a trade off between risk and return, with the highest rates being offered by the riskiest bonds. Credit rating agencies (Moodys and Standard & Poors) grade bonds according to the risk of default, with the highest quality (least risk) being classed AAA and anything below Baa (Moodys) or BBB (S & P) classed as ‘junk’. So whilst company bonds offer a higher income return and hence less of an inflation risk than government bonds, there is a higher risk that the organisation that issues them will default on the payments. In the case of a company, you are taking a business risk – the possibility that the business will fail totally or at least might not be able to meet the bond payments.

Index-linked bonds

As well as fixed income bonds, it is also possible to invest in bonds (and also National Savings products) where both the income and the redemption value are linked to the Retail Price Index (RPI). Naturally, the interest rate offered is lower than fixed interest bonds and if you want to compare them as investments you need to make some assumptions about inflation and increase the amounts you expect to receive accordingly. In the past, markets have tended to underestimate inflation and index-linked bonds did rather better than expected. That is probably less true now. The default risk is generally the same as a fixed rate bond issued by the same organisation.

Property

Investments in property (domestic, retail, industrial) provide an income stream in the form of rent. Although the person or company paying the rent may get into financial difficulties and be unable to keep up the payments, the property itself and its potential for earning rent is not normally affected in the long run. You expect to find another tenant before long and continue to receive rent for the foreseeable future. There are risks of course. Properties tend to cost large amounts of money and unless you are very wealthy it is difficult to own very many of them. A single property is vulnerable to changes in desirability: a new retail park might open on the edge of town and seriously affect the rents of smaller shops locally. A proposed new runway on an airport might put people off renting houses for miles around. A once prosperous area becomes run down, and of course a once run down area can become fashionable.

There is of course a risk that the property will be damaged in some way and unavailable to rent. Fire, flood, storm or accident damage will involve expensive repairs and probably loss of rent. Generally you can insure against these risks and you would be crazy not to. Depending on the terms of the lease you may be able to pass the cost of repair and insurance onto the tenant.

Rents on the whole tend to increase broadly inline with economic growth in money terms, and so provide some protection against loss of spending power over time. However, over fairly short periods you can expect the supply and demand for rental property of all types, and the levels of rent, to be subjected to significant local variations as well as national trends.

Equities

Owning shares in a company gives you some rights over the assets and cash flows of the business. As investors we are mainly interested in public companies with shares that are traded on a stock market, and when we buy a share in such a company we are really only interested in the free cash that the business generates. By free cash we mean any cash that the company gets by carrying out whatever it does to make money, and after paying for what it needs to stay in business and what it owes to people other than its ordinary shareholders. Unless we own enough of the company to call the shots, we rely on getting an income stream in the form of dividends and those dividends depend on generating free cash.

When you see figures showing what a good investment equities have been over long periods, it is very important to realise that by far the largest part of the return will have come from dividends. Total returns are calculated by assuming that the dividends are reinvested in the shares concerned, and at least up until recently dividends were assumed to have been reinvested without paying any tax. Nevertheless, despite this window-dressing the income stream from dividends is the reason why equities are so important for long-term investors.

The risks to the income stream are business risks. Businesses are vulnerable to changes in fashion, technology, and economic conditions, and to bad management. These changes are always with us – and so unfortunately is bad management. Even the largest companies are not immune. In fact, large companies are probably more vulnerable to crooked or incompetent managers than small ones, because it is rare for large companies to have individual shareholders with enough clout to monitor the business and prevent the directors from abusing their power or otherwise failing.

Diversifying risk

Apart from government bonds where the default risk is virtually nil, the way investors can reduce the risk associated with an income stream is by spreading it across a reasonable number of individual bonds, properties, or shares. In the case of bonds you can be pretty comfortable with a small number of high quality ones. But as you stand to lose the total investment in the case of a default, it pays not to put too many eggs in any one basket.

Although equities (shares) can be bought in quite small numbers (even just a single share if you like) the lowest dealing cost is about £12 per transaction. Unless you are buying or selling several hundred pounds worth of shares at a time, the costs are likely to make a pretty significant dent in your returns. However, you could still have a reasonable portfolio of shares for a total investment of a few thousand pounds. The alternative is to consider investing through some form of pooled fund, like a unit trust, investment trust, or exchange traded fund. We will be looking at all those a bit later.

Rental property is a difficult area for the small investor. It is hard to spread your risk across several properties and management costs (finding tenants, arranging the lease, collecting rents, sorting out repairs and other problems) will make a hole in your rents. It makes a huge difference if you can manage the properties yourself, especially if that includes carrying out or supervising repair and maintenance. Again, the alternative is to invest in property through some form of collective arrangement.

Pension funds and life assurance companies diversify their risks by virtue of their size, and if you are a member of a pension scheme of if you have an endowment policy you will be investing, albeit indirectly, in bonds, property and equities in the UK and abroad.

Risk and return for income

Modern portfolio theory, which has been a keystone of financial economics for the past 50 years, tends to overstate investment risk because it uses short-term fluctuations in returns as a risk measure. Even over quite long periods (up to ten years or so), returns to market-based investments are dominated by variations in asset prices. For example, the price of a share with a dividend yield (that’s the dividend as a percentage of the share price) of 3% (which is typical for many large companies) can change by 3% in a single day. As a result, many investments (typically equities) are seen as speculative and high-risk. Speculators make money (they hope) by moving in and out of the market and exploiting short-term price volatility using increasingly esoteric derivatives (we will talk about those later). But whilst their shares are going up and down like a yo yo, many sound companies are quietly going about their business, generating cash, and paying some of it out to their investors.

Unless share prices move so much that they begin to affect the national economy (the Great Crash of 1929 for example), businesses are not concerned about the price of their shares. Private companies and small businesses don’t have their shares quoted on any stock market and they represent roughly half of the UK and US economies. The value of a business is the present value of all its future free cash (see timing above). Since individual shareholders in public companies don’t as a rule own enough shares to be able to control the use of its free cash, the value to us of the shares we own is the present value of all future dividends from those shares. The risks to that value are business risks as long as we hold the shares. But it’s the market risk that give equities a bad name, and we look at that next.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page