Spin-Free Guide to Income

Contents Understanding the income challenges facing investors today 3 Risk and reward 4 Income from equities 6 Income from fixed income 8 Understanding bond yields 9 Income from commercial property 10 Things to consider 11 Glossary 13 Spin-free guides 15 Please refer to the glossary found on pages 13 and 14 for an explanation of the words highlighted in bold throughout this guide. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to a financial adviser. The views expressed in this document should not be taken as a recommendation, advice or forecast.

Understanding the income challenges facing investors today A difficult environment for income investors Low interest rates and several longer term factors make It is particularly important to remember that if the it hard to get an income from cash income you receive on your savings does not keep pace with the rising cost of living (ie the inflation rate), your If income doesn’t keep pace with inflation, your purchasing power will reduce over time. In other words, purchasing power falls over the years your money will buy you less of the same goods in the You may need to explore other investment options to future than it can today. achieve the income you need Taking all this into account, individuals are recognising The legacy of the global financial crisis has made life the need to put cash to work to generate a better level difficult for savers. Across much of the developed world, of income from alternative sources. policymakers, such as central bankers and politicians, In this guide, we outline some of these options for have looked to revive economies with historically low generating income. interest rates. This means keeping cash in the bank has generally paid very little reward. As such, drawing an Please remember that up to £75,000 of your money income from savings alone may no longer be sufficient is secure in a bank or building society through the for many people to maintain the lifestyle they expect. Financial Services Compensation Scheme, unlike stocks and shares or fixed interest investments which are less secure. 3

Risk and What is risk and reward? When it comes to investing for income, it is important to review your reward attitude to risk versus reward. Risk reflects the chance your investments could fall in value More risk normally means more potential for growth or income If you choose a low-risk investment, the initial sum invested is not expected to grow very much. But if you choose a higher risk investment, your initial sum could grow or reduce considerably. It is also important to keep a sufficient level of cash available for short- term needs and to fully understand the potential risks involved in investing. No financial asset is always either ‘risky’ or ‘safe’ and the risk/reward characteristics of different assets will change depending on the length of time over which you wish to invest. Levels of risk While there are varying levels of income available across the different asset classes, it is worth bearing in mind that investing in assets that pay higher levels of income can increase the risk of capital loss. This is because higher levels of income are often available as ‘compensation’ for taking on greater risk. Before choosing a particular income strategy, it is essential that investors are comfortable with the level of risk involved. Risk is the possibility of losing some, or all, of your capital (your original investment). Risk refers to uncertainty. All investments carry a level of risk. 4

Risk and Two ways to generate an income are by investing in equities, that is, company shares, or in bonds where you lend money to a government or company. Both involve more risk than keeping your money in cash. If a company does well reward continued and is profitable, equity holders usually receive a share of the profits in the form of a dividend. If the company does not do well, shares may fall in value. Bond holders expect regular interest payments and for the loan to be repaid to them at the end of the fixed term. However, there is a risk a borrower might get into financial trouble and be unable to pay interest or repay its loan. An income strategy One way to make decisions about income investing is to ask yourself three simple questions: What level of income do I need? How often do I need to be paid? How much risk am I willing to take on to achieve the income I want? Investing with an expert Rather than managing your own investment portfolio, you may choose to invest in a fund. A fund is an investment vehicle where the money of many investors is pooled to buy a portfolio of equities, bonds or other assets – which is managed by a professional fund manager – to achieve a particular investment objective. Some funds pay income to their investors in the form of distributions. The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested. 5

When you buy a share, you become part owner of a business Income from Some businesses share their profits with their owners in the form of dividends equities If a company does well, its dividends tend to grow over time, but there is never a guarantee dividends will be paid Equities are issued by companies aiming to raise money A share of the profits by offering a share of ownership in the company Dividends are a share in the profits of the company paid to investors. The most common way of investing in to shareholders and will vary depending on the company’s equities is by buying shares of companies listed on a business strategy and how well it is doing. The directors stock exchange. of the company will decide how much profit – if any – is For growth and for income to be paid out in the form of a dividend to shareholders, and how much profit should be reinvested in the company The value of shares will fluctuate depending on how to drive future growth. much investors are willing to pay for them at different times. This is affected by a number of factors, such as the past fortunes of the company, perceived prospects for the business, broader economic trends or simply investor sentiment. Investors make money in shares by selling them for more than they bought them for. In this way, equities can provide capital growth. It is also possible to generate income from equities in the form of dividends. 6

Income from equities continued The potential to rise over time can go up or down and unexpected factors can affect a An attractive feature of financially stable companies’ company’s ability to pay dividends. One approach is to dividends is that they tend to grow over time. Firms often spread risk by investing in many different companies at attach great importance to increasing their payout to once. For some people, the most efficient way of doing shareholders. This is known as a progressive dividend this is through investing in a fund. policy. If a company is able to grow its dividend over Investing for dividends time, there is potential for its shares to deliver a rising income stream, which may help offset the effects of If you hold company shares directly, any dividends will inflation. Furthermore, dividend growth is often viewed be paid to you as the shareholder, but if you’ve invested as a measure of a company’s long-term strength, which in equities through a fund, the dividends are paid to the is also an important consideration for those seeking fund. The fund may pass dividends on to investors in the capital growth. form of distributions. Before investing, you should find out whether a fund makes distribution payments and if they The risk of losing money do, how frequently they are paid. Making a call on the right companies to hold for capital The value of investments will fluctuate, which will cause growth and income can be complicated and risky. Share fund prices to fall as well as rise and you may not get prices – and, therefore, the value of your investment – back the original amount you invested. 7

When you invest in bonds, you lend money to governments Income from fixed and companies They agree to pay you interest, plus the original amount back at the income end of the loan This means there is the potential for a stable income, but the borrower may fail to keep up with repayments Fixed income, or bond, investments are loans made The chance of a loss by investors to governments (government bonds) or While income payments are fixed, the price of the bond companies (corporate bonds) seeking to raise money can go up or down as bonds are traded in the marketplace, by issuing debt securities. The borrower makes interest although over the long term, prices tend not to fluctuate payments to the investors in the form of ‘coupons’, as much as company share prices. Therefore, it is possible and pays the original investment back at the end of the to make a profit on a bond and achieve some capital term of the loan (‘maturity’), which can vary from a few growth. However, it is also possible to make a loss. Because months to many years. bond prices can move, the value of your investment can What is a coupon? also change as the return on the bond (also referred to as Coupon payments mean that you could receive a stable, the yield) can vary. regular income. If the coupon is fixed, you will generally know the exact amount of income you will receive, and when it will be paid. This can make it easier to plan ahead. Income: coupons Fixed coupon investments offer little scope for income You often know exactly how growth, however, and may not have the potential to keep much you will receive, assuming pace with inflation. Some bonds are index-linked, which the issuer doesn’t miss payments. means the coupon will be adjusted over time to provide some protection for your income against inflation. Capital return Different levels of risk If you buy a bond from another It is important to remember that bonds are not ‘risk-free’. investor for less than its original There is always the risk that the government or company cost, you could make a profit by you have lent to will fail to keep up with payments. The holding it to maturity. higher the perceived potential for this to happen, the higher the income payment you will usually be offered. 8

However, even the supposedly ‘safest’ bonds can Understanding experience meaningful price movements as factors such as interest rates and inflation have a significant bond yields impact on prices. Corporate bonds Corporate bonds generally offer a higher income than government bonds as they are perceived to be riskier investments. However, there is, as with government Bond coupons and bond yields are two different things. bonds, also a hierarchy of risk/return potential within Coupons are usually fixed, while yields vary. The yield the corporate bond sector. Investors can identify those is calculated by dividing the coupon by the price of the firms that present potentially greater credit risk by bond, and since prices can move, yields also change. the credit ratings given to companies by independent For example, if the UK government issues a bond at £100 ratings agencies. with a 5% coupon, the coupon payment will always be Investment grade bonds are issued by firms that £5. At issue price, or ‘par value’, the yield is also 5%. If are believed to be in a comparatively stable financial the price of the bond falls to £90, the coupon is still £5, but position. These bonds are generally considered to be the yield rises to 5.5%. On the other hand, if the price rises relatively safe investments with less credit risk, and to £110, the coupon is still £5, but the yield falls to 4.5%. therefore have a higher credit rating and usually offer a This is why, if you need a certain level of income, the price lower level of income. you pay for a bond is important as well as the coupon. High yield bonds are issued by firms that are perceived Government bonds to have low credit quality. They are so-called because Government bonds are generally considered some of the they offer particularly high levels of income due to the safest types of investment. However, the risk and reward fact that they are believed to be less financially secure. potential of government bonds varies across issuing Investors who are willing to lend money to these riskier countries according to the stability of their governments companies may be offered very attractive real returns. and economies. Investors should be able to identify those The high yields are offered in part to compensate governments that present potentially greater credit investors for the potentially greater risk that these risk by looking at the credit ratings given to different issuers may not make their interest payments or repay countries by independent credit ratings agencies. their loans. Governments that are considered to have a low chance of default (inability to make interest payments or repay The value of investments will fluctuate, which the initial loan) will generally offer lower levels of income will cause fund prices to fall as well as rise and from their bonds than those where the chance of default you may not get back the original amount is believed to be higher. you invested. 9

Commercial property offers the scope for capital growth and an Income from income from rental payments commercial It is normally seen as less risky than shares, but more risky than bonds property Commercial property is a term for the buildings that are Tenants and leases used for business, such as offices, warehouses and shops. Commercial property is generally rented out to a tenant Because of the required size of investment needed to buy who holds a lease on the property for a fixed period of commercial property, most people will only invest in this time. The lease will have a pre-agreed end date and asset class by buying shares in companies that own and a rent which will be paid on a regular basis, providing manage property or through investing in a property fund. a predictable, regular income for the term of the lease. A fund may own shares in property companies and/or Rents are generally reviewed every five years and are invest directly in physical ‘bricks and mortar’ property. usually only revised upwards. Income focused One risk to be particularly aware of is that property tends While it is possible to achieve capital growth through to be more difficult to sell quickly than shares or bonds. property investment (in other words, if the property were Therefore, you may not be able to sell out of a property sold for more than the amount it cost to buy), property fund as easily as other types of fund. income tends to be the key driver of overall returns. The value of investments will fluctuate, which will cause Of course, capital loss is also a possibility if the value of fund prices to fall as well as rise and you may not get back the property falls. the original amount you invested. 10

Things to consider While cash deposits may provide security of your money, risk-free. Capital loss can occur, particularly in a volatile or capital*, as well as instant access, income from cash interest rate environment. It is important to remember will fluctuate according to interest rates. In low interest that there is a hierarchy or risk/return potential within the rate environments, cash may provide very little income. asset class, according to the perceived creditworthiness This can be especially detrimental to purchasing power if of the issuer – in other words, how likely it may be to the rate of inflation is higher than interest rates, as your default on the loan. Also, while the amount of income capital will be growing more slowly than the price of the payable is fixed by the coupon, the value of the income goods you wish to buy with it. (the yield) will fluctuate as bond prices go up and down in the marketplace. Higher levels of income may be available to those willing to invest in other financial assets. However, using cash Considering commercial property to buy other assets that may potentially generate higher Commercial property offers the potential for both income income will mean taking more risk. growth (through rent reviews) and long-term capital Considering equities growth (through rising valuation of the property). However, there is also potential for capital loss, and although the Equities offer the potential for rising income over income stream could be fairly stable due to regular, fixed time through dividend growth. However, income is not rent payments, it is not guaranteed. The length of time guaranteed and equity prices can fluctuate considerably that can be involved in buying and selling properties in the short term. This means that, although there is makes this a less flexible asset class than equities and potential for significant capital gain, equity investors bonds, in terms of access to your capital. must think carefully about their time horizons and capacity for capital loss. *Up to £75,000 of your money is secure in a bank or building Considering bonds society through the Financial Services Compensation Scheme, unlike stocks and shares or fixed interest investments which are Fixed income securities or bonds, typically offer less less secure. potential for income growth than equities, but more certainty and regularity in terms of knowing the amount of income you should receive. However, bonds are not 11

Things to consider continued The value of diversification Consider your individual needs One well-established way of trying to manage investment Achieving the right combination of investments will risk is diversification. This is achieved by investing in require careful consideration of the characteristics that a blend of asset types that offer diverse characteristics different assets may offer, in the context of your individual and have the potential to behave differently in various circumstances. Investors need to think about whether economic or financial market environments. The essential they need a guaranteed income or if they are able to take principal of diversification is to avoid ‘putting all your some risk with their capital to aim for higher income. eggs in one basket’. This may provide the best chance of Important information generating a sustainable income stream for the long term. We are unable to give financial advice. If you are unsure The risk/return trade-off about the suitability of your investment, speak to your Achieving the right diversified blend for your needs will financial adviser. The views expressed in this document require careful consideration of the characteristics that should not be taken as a recommendation, advice different assets may offer, in the context of your individual or forecast. circumstances. Investors need to think about whether they need a guaranteed income or if they are able to take The value of investments will fluctuate, which will cause some risk with their capital to aim for higher income. The fund prices to fall as well as rise and you may not get back typical trade-off between higher return and higher risk is the original amount you invested. a basic principle of investing and should always be borne in mind. A diversified portfolio could be more stable as the You should also think about what you need the income market rises and falls. Combining bonds, equities and for, and over what time horizon. Different financial goals property may reduce the impact of shocks. will require different types of income stream. You may want to aim for steady, regular income or it might be more appropriate to try and achieve income growth over time. If you are unsure about the most appropriate way of generating income for your needs, please speak to a financial adviser. 12

Glossary Investment terms The following are explanations of some of the terms you would have come across in this guide. Asset governments as they are often considered more risky. Diversification Anything having commercial or exchange value that Coupon The practice of investing in a variety of assets. Ais owned by a business, institution or individual. The interest paid by the government or company This is a risk management technique where, in a that has raised a loan by selling bonds. well-diversified portfolio, any loss from an individual Asset class holding should be offset by gains in other holdings, Category of assets, such as cash, company shares, Credit rating thereby lessening the impact on the overall portfolio. fixed income securities and their sub-categories, as An independent assessment of a borrower’s ability well as tangible assets such as property. to repay its debts. A high rating indicates that the Defaulted/Default Bond credit rating agency considers the issuer to be at low When a borrower does not maintain interest A loan in the form of a security, usually issued by risk of default; likewise, a low rating indicates high payments or repay the amount borrowed when due. a government or company, which normally pays a risk of default. Standard & Poor’s, Fitch and Moody’s Distribution fixed rate of interest over a given time period, at the are the three most prominent credit rating agencies. Refers to the periodical paying-out of interest or end of which the initial amount borrowed is repaid. Default means that a company or government is dividends received by funds to their shareholders. unable to meet interest payments or repay the initial Capital investment amount at the end of a security’s life. Dividends represent a share in the profits of a Refers to the financial assets, or resources, that a company and are paid out to the owners of company company has to fund its business operations. Credit rating agency shares at certain times during the year. A company that analyses the financial strength of Capital growth issuers of fixed income securities and attaches a Dividend Occurs when the current value of an investment is rating to their debt. Examples include Standard & Dividends represent a share in the profits of greater than the initial amount invested. Poor’s and Moody’s. the company and are paid out to a company’s shareholders at set times of the year. Corporate bonds Credit risk Fixed income securities issued by a company. They can Risk that a financial obligation will not be paid and a Equities offer higher interest payments than bonds issued by loss will result for the lender. Shares of ownership in a company. continued on next page 13

Glossary continued Fixed income security/securities Inflation Risk A loan in the form of a security, usually issued by a The rate of increase in the cost of living. Inflation is The chance that an investment’s return will be different government or company, which normally pays a fixed usually quoted as an annual percentage, comparing to what is expected. Risk includes the possibility of rate of interest over a given time period, at the end of the average price this month with the same month a losing some or all of the original investment. which the initial amount borrowed is repaid. year earlier. Yield (income) Government bonds Investment grade bonds Refers to the income received from an investment and Fixed income securities issued by governments, that Fixed income securities issued by a company with a is usually expressed annually as a percentage based normally pay a fixed rate of interest over a given time medium or high credit rating from a recognised credit on the investment’s cost, its current market value or period, at the end of which the initial investment rating agency. They are considered to be at lower risk face value. is repaid. from default than those issued by companies with lower credit ratings. Default means that a company High yield bonds or government is unable to meet interest payments or Z Fixed income securities issued by companies with a low repay the initial investment amount at the end of a credit rating from a recognised credit rating agency. security’s life. They are considered to be at higher risk of default than better quality, ie higher-rated fixed income securities Maturity but have the potential for higher rewards. Default The length of time until the initial investment amount means that a company or government is unable to of a fixed income security is due to be repaid to the meet interest payments or repay the initial investment holder of the security. amount at the end of a security’s life. 14

guides This brochure is part of our range Spin-free guides aim to give you the basics of Spin-free guides: about investing, to help you make informed decisions about your financial goals and how Investing to reach them. Equities The value of investments, and the income from them, will fluctuate which will cause the fund price to fall as well as rise and you may not get back the original amount you invested. We are unable to give financial advice. Risk Income If you are unsure about the suitability of your investment, speak to a financial adviser. The views expressed in this document should not be taken as a recommendation, advice or forecast. Bonds Property 15

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