The reputation of governments as guarantors of last resort has hardly fared better. Investors and savers interested more in protecting their capital than growing it see two ferocious dogs running at them, teeth bared – bankruptcy and inflation.
Inflation danger
Source: Financial Express Analytics
Credit risk is not a new concept but the idea that a major bank could default surprised and scared everybody. Governments default in their own way. Massive capital injections into banks, commercial paper and other asset markets have brought government deficits to unprecedented levels. The almost universal solution is inflation.
There is a more parochial way of looking at this. The three year gilt pays just over 2 per cent. Bank deposits might earn 3 or 4 per cent at a push. So how is it possible to retain liquidity, increase yield (and therefore compensate for the inflation risk) without taking too much credit risk? There are five product solutions. But each have their wrinkles.
TIPS or index-linked gilts give you government risk with an inflation protection kicker. The art is to buy them close to par or at issue. Since these instruments can be adjusted upwards only you will not be caught out in periods of deflation.
Dividend paying shares also contain a trap. Most of the higher yielding stocks are heavily indebted property investors or utilities. Your dividend is being paid by increasing leverage and may not be sustainable. Other large payers, like Man Group and Pearson, may have volatile operating businesses, unable to fulfil the dividend 'promise' in all economies. Which leads us to…
Bonds. If well chosen these can have almost the opposite risk profile to the high dividend yielding stocks. A properly analysed bond will pay out in most situations and, even in default, will preserve capital. The paradox in this case is that many bond funds are concentrated on bank risk, the worst sector for certainty.
Some companies are able to provide value at both the dividend and bond level. Cable & Wireless, the international telecoms group, has strong cash flows that easily service its modest net debt. Its well covered dividend offers a current yield of 6 per cent. But its bonds, which by definition are even safer than the shares, produce an annual return of 7 per cent over the next three years.
To round off the set let me mention Preference Shares and their junior partners Zero Dividend Prefs. These are roughly equivalent to bonds but suffer from limited availability.
A well constructed portfolio of the above instruments can yield 7 to 10 per cent without taking substantial capital, credit or inflation risk.
Richard Simmons is an Investment Manager with Credo Capital. He manages portfolios over £500,000 on a discretionary basis. The views expressed here are his own.