Investment

The hunt for income

Lower interest rates will ultimately help the economy and so benefit charitable schools. However, lower rates means lower returns on cash and so will put more pressure on generating income, says John Hildebrand

Charities hold cash for a variety of reasons, ranging from those needing it for working capital to those building reserves for tougher times. The reasons for holding the cash will influence what charities can do with it, but for all charities often the best way of generating higher returns is to take more risk. So, what are some of the options available to charities and how risky are they?

The options available to any investor depend on the amount of money they have available and the length of time they can afford to be without it. Risk can be lessened by placing assets with a range of institutions and by understanding how the return is being generated. One of the lessons learnt from those who had money with the Icelandic banks was that if a rate sounds too good to be true, it probably is. Schools will now have to work out
whether they are taking on too much risk if they choose a certain counterparty with which to place their money.

Starting points
The first way to generate a higher return is to lock it away for a longer period or “term”. Term deposits also allow their holders to fix the rate at a time when they feel interest rates are high. The trouble is that rates are no longer high and investors are unlikely to want to tie their money up. In addition, term deposits mean that money is
held at one bank.

Money market funds amalgamate the monies of many different investors and provide diversification by placing
it across a range of banks and government bodies. They also offer the ability to withdraw funds quickly and have
returns currently slightly above base rates. However, being unit trusts, most with the possible exception of some
Charities Aid Foundation (CAF) accounts are unable to make a claim under the Financial Services Compensation
Scheme. Both CCLA and CAF offer funds for charities; groups such as HSBC, Fidelity and Goldman Sachs also
offer these funds for institutional investors. This can mean these funds have high minimum investments.

Cash Plus funds are money market funds that aim to offer more attractive returns by investing in a wider range of assets and for longer periods. Working on the principle that all investors are unlikely to want their cash back at the
same time, they invest a larger proportion of their assets in longer dated deposits and so can generate higher
returns at slightly higher risk.

Government bonds, or gilts, offer another way of generating returns above deposit rates with a higher level of security. However, investors have already heavily invested into the short end of the market and so are forced to look at the more volatile longer end of the market. This part of the market could suffer if higher inflation rates return or the government significantly increases the supply of gilts, which could leave charities facing losses in capital. The Treasury 4.75 per cent 2020 has a gross redemption yield of 3.4 per cent, meaning that if the charity holds this stock until 2020 its total (capital plus income) return would be 3.4 per cent per annum.

Dropping returns
Over the last two years, the yield on ten-year gilts has fallen from 4.7 per cent to 3.0 per cent. This fall in yield
reflects the sharp increase we have seen in risk aversion from global investors. Over the same period, the yield on
investment-grade corporate bonds (BBB- and above) has risen from 5.3 per cent to 6.8 per cent. This means that
whereas two years ago corporate bonds had a 0.6 per cent higher yield to compensate for the higher level of risk,
that difference today is 3.8 per cent.

Investors considering corporate bonds have to balance this higher return with the risk that the level of corporate
defaults rises. In practice, the level of corporate defaults is likely to rise, given that we have just entered a recession. However, markets are already pricing in a higher level of company defaults than in previous recessions and so currently offer good value. In addition, should we enter a period of high corporate defaults, bondholders are higher up in the queue than shareholders. Consequently, in the event of liquidation, there is more likelihood of getting some of your money back.

To lessen this risk, charities should look at a range of bonds. There are a number of bonds that can currently
be bought in non-financial companies with a relatively defensive revenue, such as companies in the utilities, food
retailing and oil sectors. Alternatively, there are a wide range of corporate bond funds available with relatively
low charges.

Distant horizons
For charities willing to take a longer-term view, equities now offer attractive yields and the probability of a rising
income stream over the long-term. Even allowing for the cuts in dividends from the banks and from other
companies that might reduce their dividends, the sustainable yield on UK equities is likely to be well in
excess of the 3 per cent available from ten-year gilts. So, equities offer charities a chance to lock into a reasonable
yield and one which is likely to grow over the long-term.

Consequently charities, faced with rates of interest that could well be as low as 1 per cent in several months’
time, can still lock into attractive returns. As always, it is important to think about what the aims are and how to
balance the wish to maximise returns while not taking excessive risk. For charities with a long-term horizon, the
best way of achieving their aims is to diversify across a range of assets. Corporate bonds look attractive, longer-term funds should maintain their equity weightings and, where cash is being held, money markets funds can be used to ensure that the cash is being worked as hard as it reasonably can be.

John Hildebrand is senior investment director – charities for Rensburg Sheppards Investment Management.

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