Derby District & Law Society (D& DLS) magazine - January 2010
In my previous article I considered the issue of ‘WHY INVEST’, or more particularly why would anyone choose to invest given the recent economic problems and the extreme fluctuations in the value of investments.
If you missed the article, the short answer is that asset backed ‘real’ investments are the only way to ensure that the purchasing power of your money exceeds the rate of inflation by a meaningful amount over the long - term. The reason why this is the case is linked to one of the key contributors to growth in asset values (for more details see page 10 of the January 2010 D & DLS Bulletin).
So if either you, or your clients, have realised that they either want or need to invest in a balanced spread of investments to have the potential for better performance than simply leaving the monies in deposit based arrangements – what investments are available?
There are a bewildering array of different types of investments available and all manner of terminology and different tax structures that can sometimes ‘muddy’ the picture. However, whatever investment or ‘tax wrapper’ that is proposed to you, the most important factor to focus on is:-
What is the underlying investment that is being made? The reason that this is so important is that this is what will enable you to identify the nature of the Risk involved and it is the underlying investment that will drive the ultimate performance of the investment. Any tax benefits should be secondary, as you should never let the tax tail wag the investment dog – particularly as you don’t pay tax on losses!
In this article I am going to provide a brief description of two of the different asset classes available; namely Cash and Fixed Interest investments, as well as their uses in a portfolio. In my next article I will provide details on Stocks and Shares, Commercial Property and Alternative Investments.
Cash provides a known level of income, however, it does not provide any capital growth. It is crucial to have the right amount of money in cash. If you are forced to sell assets when they have fallen in value, you are crystallising what would otherwise be a ‘paper loss’. Holding all known spending for the next five years or so, plus an adequate emergency fund in Cash ensures that you are not forced into this situation.
Cash is classed as low risk, as the value of the capital does not fluctuate. However, it is important not to hold too much cash, as over the - long term this has traditionally failed to keep pace with inflation. The effects of inflation are often under estimated, for example, inflation of 4% a year will halve the buying power of money over 15 years. Only ‘real’ investments have historically beaten inflationary rises over the long term.
It is also important to note that deposit accounts often do not work well for higher rate taxpayers or for Trusts subject to the Rate Applicable to Trustees (RAT). For example even if they can achieve 4% gross, this is only 2.4% net of the current 40% higher rate tax (this will rise to 50% in April), which is roughly equal to the target rate of inflation that is set for the Bank of England (this is 2%, with a letter required to be sent to the Chancellor of the Exchequer if it falls below 1% or rises above 3%) i.e. the deposits are only keeping pace with inflation, there is no ‘real’ growth.
In the same category as cash is debt and we advocate the payment of debt prior to investment in virtually all cases (one exception might be where the interest could be offset against taxable income). Ensuring that individuals and Companies pay down as much debt as possible will become more important if the economic environment does not improve.
Fixed Interest investments
These can be split into:
A - Gilts or Loans to the Government, where you receive a fixed interest rate and your capital back at the end of the term.
The value is only guaranteed if you purchase the Gilt at or below the value it will be redeemed at and you hold the Gilt to maturity. If interest rates, or the outlook for inflation falls, it should be possible to sell the Gilt for a capital profit, as your Gilt pays a higher interest rate than a new Gilt would (unless other factors come into play, such as the UK credit rating is downgraded).
However, if interest rates or the outlook for inflation rises and you sold the Gilt prior to maturity, you would probably make a capital loss, as your Gilt pays a lower interest rate than a new Gilt would.
B - Corporate Bonds, which work in the same way as Gilts, except that they are loans to companies. They usually pay a higher level of income than Gilts, as there is a higher risk that a company might default on the repayment of the loan or the interest payments.
This means that the outlook for the economy, default rates and the credit rating of the individual companies who have issued the Corporate Bonds will affect their value, as well as the changes in interest rates and inflation detailed above for Gilts.
There appears to be some value in some Corporate Bonds at the moment, as the difference between Gilt yields and Corporate Bonds has widened, although this is in return for a higher level of risk. Whether Corporate Bonds offer good value is usually determined by looking at the extra return available over the ‘risk free’ returns on Gilts. If the yield on Gilts was to rise quickly, which could happen as a result of interest rates rising or due to the sheer volume of Gilts that the Government are going to be forced to issue over the next few years then Corporate Bonds could quickly fall in value.
A sensible overall plan
Professional Financial Centre (East Midlands) Ltd has successfully helped many clients to put a sensible financial plan into place that will last them for the rest of their lives. When looking at the huge choice of investments available we are able to prove that we only have your interests at heart. We do not have any vested interest in choosing one particular product or course of action over another. As changes happen, we review our clients’ plans, adjusting them to meet changing economic circumstances and family needs. If you want to challenge us to do the same for you or your clients, you will not be disappointed. If you simply want a second opinion, our view on your existing holdings, or have a general query about financial matters, please call us.
Professional Financial Centre (East Midlands) Ltd is a local financial services resource for Legal and Accountancy firms who do not operate in house Financial Services departments. We share the same ethos as Professional firms, in that we act purely in our clients’ interests, operating solely on a fee basis and accounting to our clients for any commissions. As a result of our qualifications, experience and culture, we qualify to be included on the SIFA Professional Directory of IFA’s, which is endorsed by the Law Society. The database can be seen at www.sifa-directory.info.