Fixed income investments have risen in popularity year on year as more and more investors seek out new ways to generate a predictable and regular income from their capital. This popularity increases none more so than at this time of year, when the additional feature of receiving income tax free when holding your investment plan within an ISA is another reason to consider your options. So with ISA season upon us, and whilst savings rates continue to force many to consider taking on more risk with their capital, we take a look at what fixed income investments can offer and how to compare the latest plans available.
The here and now
Not only have fixed income investments been one of the real success stories in recent years having seen a significant surge of interest since the stock market crash of 2008/9, but this interest seems to be increasing as the needs and demands put on more of us from our capital fails to be met by traditional products, which often have variable and less predictable income.
Savings rates have also fallen dramatically over the same period with top five year fixed rate bonds currently paying around 3.0%, whilst fixed rate Cash ISAs are much lower at around 2.4%. So fixed term deposits are failing to deliver the returns so many cash savers had grown used to, causing many to consider having to take on more risk with some of their capital.
What is a fixed income investment plan?
The fixed income investment, or reverse convertible to give it its technical name, is a fixed term investment where the level of income received is fixed at the outset and is paid to you regardless of the performance of any specific shares or the stock market as a whole. The return of your initial investment is however determined by the stock market, which in usually based on the performance of a major stock market index such as the FTSE 100 (the Index) or a number of shares listed on the Index.
Because the income is not reliant on the performance of the stock market, investors have the benefit of knowing at the outset exactly how much income they will receive and when it will be paid. This certainty of income and timing is undoubtedly playing a key role in their popularity.
Fixed income, fixed term
Not only is the income fixed, but the term of the plan is also. The plan term is normally in the region of five to six years, thereby providing a defined period during which your capital is invested. This combination of a pre-determined fixed income paid over a fixed term creates an investment that is relatively straightforward to understand and which is more easily comparable to other income investments available in the market.
This contrasts with investing directly in shares or a UK equity income fund where in addition to your capital being exposed to daily stock market fluctuations, in both cases your income is variable and not necessarily predictable. Fixed income investments therefore offer a unique set of investment features when compared to more traditional income investments.
Popular in all markets
The defined return for a defined level of risk offered by the fixed income investment is therefore an attractive feature for many investors and since the income is paid regardless of the performance of the stock market, these investments have proved popular in both falling and rising markets provided of course that the level of income on offer is sufficiently high when compared to other income options and the level of risk taken with your capital.
What does ‘capital at risk’ actually mean?
In order to receive fixed returns that are currently far higher than those available from cash, the investor’s capital is put at risk. This means that although your income is fixed, whether you receive a return of your original capital at the end of the investment term is dependent on the performance of the underlying investment, which can be a major index such as the FTSE 100 Index, or a number of shares listed on the Index.
Fixed income investments usually contain some form of conditional capital protection which means that your initial capital is returned at the end of the plan unless the underlying investment (Index or shares) has fallen by more than a fixed percentage. This is normally set at 50% and in all cases is known prior to investing. Based on today’s opening value of the FTSE of 6,782, the Index would have to fall to 3,391 before your capital would be at risk, a level not seen since 2003. Please note that the past performance of the FTSE is not a guide to future performance.
For those plans paying a higher fixed income but where the return of your capital is dependent on the performance of shares, because individual share prices can move by wider margins than the Index as a whole, these should be considered a higher risk investment.
Counterparty risk
Since your investment is used to buy securities issued by the institution offering the plan (normally a bank), one feature that is important for investors to understand is counterparty risk. This is the likelihood that a particular institution will be unable to repay any money owed which could therefore potentially have an impact on your returns which is separate to the performance of the underlying index.
There are a number of credit ratings available provided by leading credit rating agencies such as Standard & Poor’s, Fitch and Moody’s and although these are only one way of assessing the counterparty to each individual plan, they do provide a useful starting point. In addition, a recent development has seen some plans offer the option to spread this risk by using a number of counterparties although the potential fixed returns on offer will be slightly lower.
Fixed term
Liquidity can be an important part of investing since none of us know what lies around the corner and we may need to draw on our investments earlier than planned. Unlike investment funds, daily selling prices are not always available and the secondary market for this type of investment is still developing so this is an important consideration.
Fixed income investments are certainly designed to be held for the full term, however most investments generally should be made on the basis of you not requiring the capital for at least 5 years and as such are in line with other investments. In the event of requiring the funds a value can always be obtained from the plan provider and proceeds are normally available quickly. Should you need to encash your investment before the end of the term the value could be higher or lower than your initial investment, dependent on the market value at the time.
Current selections
Fixed income investment plans currently available include the best selling Enhanced Income Plan from Investec. The current issue pays 5.28% fixed income each year, paid as 0.44% each month, whilst your capital is returned at the end of the plan unless the FTSE 100 Index falls by more than 50%, therefore offering you some capital protection should the stock market fall. However, if the FTSE does fall more than 50% you could lose some or all of your initial investment.
Offering a higher fixed income is Meteor’s FTSE 5 Monthly Income Plan (Morgan Stanley acting as the counterparty) which offers a fixed income of 7.2% each year, paid to you as 0.6% each month, again regardless of the performance of the stock market. The trade off for such a higher level of fixed income is that the return of your initial capital is dependent on the performance of five FTSE 100 shares rather than the Index as a whole. If the value of the lowest performing share at the end of the term is less than 50% of its value at the start of the plan, your initial capital will be reduced by 1% for each 1% fall, so you could lose some or all of your initial investment.
Both plans regularly feature in our newsletter’s Top 5 most requested investment plans.
Risk versus reward
Providing a high level of fixed income which is not dependent on the performance of the stock market has an obvious appeal. However, you should always remember the principle of risk versus reward which means that that the higher the return, the higher the risk.
For example, although the level of income on offer is considerably higher than the 3% or so currently on offer from leading longer term fixed rate bonds, fixed income investments put your capital at risk and so you need to both understand the risk to capital as well as be prepared to lose some or all of your initial investment in order to receive a higher level of income before you commit to investing.
Using you New ISA (NISA) allowance
Finally, all of the fixed income investments detailed by us on www.fairinvestment.co.uk are available for individuals to use their New ISA allowance and will also accept ISA transfers from both Cash ISAs and Stocks & Shares ISAs. For the current tax year the annual New ISA allowance is £15,000. So for those who are disappointed with their savings rates and investment yields, the possibility of a high level of fixed and regular tax free income might be attractive in the current climate.
Where next?
The above summary highlights the pros and cons of the fixed income investment for those looking for higher fixed returns and who are prepared to put their capital at risk. The combination of a high return that is not linked to the performance of the stock market and some capital protection conditional on the performance of the underlying investment, is unique among income investments whilst the monthly payment frequency has no doubt played a part in the popularity of these plans. The fixed term also means you know exactly how long the income will last and with all plans available within an ISA, they also have the added feature of being able to offer tax free income.
With future dividend yields from UK equities under pressure and any rise to interest rates expected to be slow and piecemeal, the pressure is on for both savers and investors to maximise the income returns they receive from their capital. The main features of fixed income investments combine to offer what could be an attractive balance of risk v reward when compared with other income investments available. The market is certainly set to grow…
Compare fixed income investments >>
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are at all unsure of the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice.
Tax treatment of ISAs depends on your individual circumstances and legislation which are subject to change in the future. ISA transfer charges may apply, please check with your provider.
The investments referred to in this article are structured investment plans that are not capital protected and are not covered by the Financial Services Compensation Scheme (FSCS) for default alone. There is a risk of losing some or all of your initial investment. There is a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index is not a guide to its future performance.
