April 2022

Apr 28

Analysing credit ratings

By FAS | Investments

Corporate and government bonds will form a part of most diversified investment strategies. However, given the high rates of inflation we are experiencing at the moment, it is even more important to select bonds that will perform well in the prevailing conditions. We use a number of tools to select appropriate bonds, and one of the factors we analyse is the bond’s credit rating.

Bond basics

Looking at the broad definition, a corporate bond is a type of debt security that is issued by a firm and sold to investors (although there are a number of different types of bond and other debt instruments in circulation). The company obtains the capital it needs from investors and in return the investor is paid a number of interest payments at either a fixed or variable interest rate. When the bond reaches redemption, i.e. when all of the pre-determined interest payments have been paid, the original investment is returned. In a similar manner, governments issue bonds to finance public spending, which are known as gilts in the UK.

Credit where it’s due

Just as individuals have a personal credit rating based on their financial security, bond issuers are usually evaluated by credit rating agencies to assess the creditworthiness of the bond. There are three main ratings agencies that undertake the evaluations of bond strength – Moody’s, Standard & Poor’s (S&P) and Fitch. Each bond rating agency considers the underlying company and its ability to meet its future obligations, by considering a number of factors, including the strength of the balance sheet, the future economic and business outlook, profit margins, and earnings growth. As a result, the credit rating provides an indication of how likely the company will pay its obligations.

Using the S&P ratings, for example, the highest-graded bonds are graded AAA with all bonds rated above BBB- being classed as investment grade. Any bonds graded BB+ and below are classed as high yield bonds, with the lowest classification being grade D, which means the bond is in default – in other words, the issuer cannot repay its obligations.

Currently, the UK Government is rated AA for its sovereign debt. There are very few governments whose debt is rated AAA, and this select list includes Germany, Norway and Canada. Unsurprisingly, Russia has seen the rating given by S&P to its debt fall to a rating of CC, which suggests a default is imminent.

Risk and reward

Generally speaking the highest graded bonds are those with the lowest chance of default. This would, therefore, make these bonds the most obvious choice for bond investors? Well, not necessarily and indeed in recent times, this isn’t often the case. Given the lowest perceived risk of default, the bonds with the highest credit ratings offer the lowest returns in terms of regular income payments, expressed as “yield” when compared to the underlying bond price. These returns have been very unattractive for a number of years, and with inflation heading northwards, the “real” return offered looks even worse.

Just as the highest-graded bonds offer the highest-perceived security, but lowest yields, those bonds with the lowest grade will need to compensate investors for the increased default risk. Thus low-graded bonds tend to offer attractive yields, although the risk of default is much greater, due to the weaker financial strength of the issuing company.

This is the reason why a portfolio approach is most appropriate when considering bond investment. Mixing a range of bonds with different credit ratings can find the correct blend of income yield and investment risk to suit the particular strategy being adopted.

Are ratings to be trusted?

Credit ratings can usually be a good guide as to the creditworthiness of a bond issuer; however, they are not infallible as the ratings are based on historic financial data. Credit ratings agencies cannot look into the future and material changes in the fortunes of a company can lead to credit ratings being downgraded. This would normally lead to an increase an yield, as investors seek higher returns as compensation for the greater risk. On the other hand, a high yield bond, where the issuing company sees a substantial improvement in its financial prospects, could potentially be re-rated to investment grade, which could generate capital returns to investors in addition to the interest payments.

One tool in the box

Whilst credit ratings are undoubtedly helpful, they cannot be used in isolation to determine whether a bond is worthy of consideration. As we have mentioned above, they look at historic data, and careful analysis of the bond issuer is needed together with regular review of how changes in profits, or economic outlook in the case of a government bond, could affect the credit rating going forward.

At FAS, we use collective investments within our strategies. These are pooled investments where a manager will buy a portfolio of bond investments to offer a spread across a range of different bonds, which will all have different criteria, including credit ratings. By analysing the constituent components of a bond fund, we can determine the average credit rating across the bond portfolio to get a feel for the level of risk the manager is willing to take.

As we have stressed above, bond investment is a complex area, where a number of different qualitative and technical analyses all contribute to the selection process. The economic conditions we are experiencing at present has, in our view, only increased the need for comprehensive due diligence. If you hold corporate or government bond funds or corporate bond investments as part of an existing portfolio, we would be happy to offer an impartial review of your existing arrangements.

If you would like to discuss the above with one of our experienced financial planners, please get in touch here.

The value of investments and the income they produce can fall as well as rise. You may get back less than you invested. Past performance is not a reliable indicator of future performance. Investing in stocks and shares should be regarded as a long term investment and should fit in with your overall attitude to risk and your financial circumstances.

Apr 21

Define your investment goals

By FAS | Investments

An important part of the financial planning process is defining the reasons why you are investing in the first place. By taking the time to consider the bigger picture at the outset, you can enhance the probability of achieving your desired outcomes, by matching appropriate strategies to your targets.

What stage in life are you at?

Broadly speaking, many investors fall into one of two categories. The first are those who are accumulating and building wealth and assets over time. These clients are often younger or middle aged and are able to save regularly (either via a pension, an investment vehicle, or both).

The second category are those who have already accumulated wealth, and are looking for that wealth to perform a function in later life. This cohort are often approaching retirement, or have already retired, and instead of looking to regularly save towards their goal, they are looking for the accumulated funds to either provide an income (through a personal or defined contribution pension, or investment plan) or achieve further growth (to provide a larger inheritance to family).

Aiming at the goal

Irrespective of which category an individual falls into, it is important to break down your thinking and define short term and long term goals. Both the short and long term goals may well aim to achieve a similar outcome, although sometimes the goals can be very different.

Take the example of a married couple aged 30, with two children. They both earn good incomes and manage to save regularly each month. After speaking to an adviser, they have considered their goals in the short term. Firstly, they want to make sure they have an emergency fund held in readily accessible funds, to provide for life’s unexpected costs. Secondly, they hope to be able to afford private education for their children. They have therefore decided to invest for the medium term by regularly saving into an investment strategy designed for growth to meet the target date at when funds could be needed to fund private education costs, by funding regular withdrawal to meet the expected annual costs.

In the longer term, they want to make sure that they can afford a comfortable retirement and therefore are also committing funds into a pension arrangement, to try and achieve a good level of pension savings from which to provide retirement income.

The three goals (two short term, and one long term) have completely different time horizons, and therefore it would be appropriate to consider investing in a separate strategy for each goal. In this way, the most tax efficient method can be selected, and the choice of investments be tailored to suit the target of each goal. This is certainly a more sensible approach than simply holding a single savings pot, that doesn’t match any of the stated objectives.

For clients reaching retirement, the goal of many is to provide a sustainable retirement income. This can be achieved via a number of methods, using existing pensions, and investments accumulated through life and also possibly through inheritance. For these clients, defining the level of income needed to meet expected outgoings is very helpful in tailoring the strategy to generate the correct level of income. These clients often have other objectives in mind, for example, the ability to pass on wealth earlier to younger family members by way of gift. Again, careful thought and planning can maximise the tax efficiency of these transactions.

Lastly, the longer term objectives may be to leave significant wealth to the next generation in a tax efficient manner. The three objectives identified are likely to impact on each other, and clearly defining goals and targets at the outset can help prioritise your goals and aspirations.

Review and revisit

Whilst giving careful consideration and clearly defining investment goals is an important part of the planning process, reviewing and revisiting those goals is equally important for two reasons.

Firstly, goals change over time. Life is often unpredictable and life events and changes of plan can lead to a clearly defined goal at the outset becoming less important. Let’s look again at the married couple in our example above. They receive an unexpected inheritance that covers the private education costs for their children and therefore they do not need to plan for this expense when the children reach school age. They can, therefore, alter their priorities and focus on their other short and long term goals.

Secondly, it is important to review and consider whether investment goals remain achievable by considering performance of the investments regularly to see whether they are on track to reach their target. If investment markets are underperforming, committing greater savings to the stated goal could help get the plan back on target. Conversely, if investments perform above target, this may allow regular savings investments to be reduced, releasing funds for other uses.

Engage with a holistic financial planner

Planning for investment goals is an important area where holistic financial planners can add significant value. By engaging with a trusted adviser, they can assist in defining investment goals at the outset and work with you over time by regularly reviewing your goals and expectations and whether the strategies put in place are on target to achieve that goal.

At FAS, we always take a holistic view, and really take the time to understand your investment and financial goals. Our comprehensive regular reviews not only cover the performance of recommended investment strategies, but also whether these are on target to meet your goals, and whether any changes to the strategy are needed.

If you would like to review your investment plans to see whether they meet your goals, then please get in touch with our experienced financial planners here.

Apr 14

Make cash work harder

By FAS | Financial Planning

The so-called “cost of living crisis” is never out of the news at the moment, with the hike in energy prices, petrol, and food costs causing concern for many. Headline UK Consumer Price inflation rates have now exceeded 6% per annum, and with expectations that annual inflation could reach double digits by the autumn, many are considering how to give their income a welcome boost.

Feeling the squeeze

One group in particular who are likely to feel the effect of the price hikes more than others are retired individuals, where income levels are not keeping up with the general rising prices. The reference point that sets the annual increase in State Pension is the rate of inflation at the September preceding the end of the tax year, and as a result, the State Pension has only increased by 3.1% this year, lagging behind the current rate of inflation by some margin.

Retired individuals who hold savings on cash deposit have had to live with low interest rates for more than a decade, so in some respects conditions at the moment represent the status quo. However, the big difference this year to previous years is the fact that the gap between savings rates and inflation has widened, and this trend is only likely to strengthen during the remainder of the year.

The quest for better rates

A simple option for those who are receiving a disappointing rate of interest on their savings is to look to move funds to an account paying a better rate. The Bank of England have increased base interest rates on three occasions since December last year, and in an attempt to tackle the persistent higher rates of inflation, are likely to increase rates further during the remainder of this year. Our current expectations is that the Bank of England will hike rates a further three times before the end of the year, although the continued uncertainty over the price hikes and growth could see the Bank take a more aggressive stance if necessary.

That being said, the pursuit of improved cash interest rates remains an exercise in frustration, despite the likelihood of cash interest rates offered by banks and building societies improving during the course of year. As much as cash savings rates improve, the prevailing rate of inflation is likely to have risen further, maintaining and even increasing the difference between the cost of living and savings rates.

Look to alternative options

So what can investors do to generate much needed income and also aim to add some growth into the mix to offset the rising prices?

By considering alternative assets to cash, such as fixed interest securities and equities, more attractive levels of income can be generated. Naturally, moving away from cash deposits introduces investment risk, which is not present when holding cash (although as we have shown above, cash is not risk-free, as inflation risk can be significant). Investment risk can be mitigated in a number of different ways. By holding a diversified portfolio, with allocations to different assets that look to balance out assets that have potential for greater returns, with those that offer more predictable returns. In addition, stock specific risk can be avoided by investing in pooled funds (such as Unit Trusts or Open Ended Investment Companies) that spread the investment across a wide range of different individual positions.

Let’s take a look at those alternative asset classes in more detail. Corporate bonds, government bonds, and other fixed interest securities are loans, where the investor lends capital to the issuing company or government. In exchange, the bond provides a regular income for a fixed period of time, with a set return of capital offered when the bond redeems. These investments tend to be more predictable than equities (company shares) but they do still carry risks. These risks include default risk, where the issuer of the bond is financially unable to repay the capital or interest. This risk can be minimised by careful selection of who to lend your money to.

Dividend income generated from equities (company shares) are regular distributions of capital to shareholders. The ability of a company to pay dividends relies on the company having sufficient capital to make the distribution, and are not fixed. Dividend yields came under significant pressure during the early stages of the pandemic, but more recently, dividend yields have improved. Unlike fixed interest securities, equities tend to be more volatile in terms of their capital value, which shows greater fluctuations over time. That being said, equities have greater potential to provide capital returns, and once again, with careful management, the risks can be managed through diversification into assets held in different sectors of the economy and geographic locations.

It’s all in the blend

By blending these assets classes, together with other assets that complement the overall strategy (such as infrastructure or property) cash savings could be better employed to generate more attractive levels of income and over the longer term, aim to provide some capital appreciation. Holding these assets in an individual savings account (ISA) can enable a tax-free income to be generated and this is often a sensible way of generating additional income, particularly for those who rely on fixed incomes, such as in retirement.

Moving away from cash and into investments such as fixed interest securities and equities can be a big step and this is where expert financial planning advice can add significant value. The advisers at FAS can provide impartial advice on the options open to you and construct a discretionary managed or advisory portfolio designed to meet your income needs.

If you are looking to make cash worker hard for you, then please get in touch with our experienced financial planners here.

Apr 07

Feather duster, a pair of marigold gloves, and a calculator representing a financial spring clean

New tax year – time to spring clean your finances

By FAS | Tax Planning

With warmer weather approaching (well in theory anyway!) and another tax year upon us, now is an ideal time to review your financial arrangements, to take advantage of a new set of tax allowances and consider how hard your money is working for you.

Make best use of your ISA allowance

The Individual Savings Account (ISA) is a mainstay of annual tax planning and for most people, making use of the available ISA allowance is a sensible way forward. The ISA allowance remains at £20,000 for the 2022/2023 tax year (the sixth tax year in succession where a £20,000 limit applies). All income generated within the ISA is exempt from income tax and gains made on assets held in the ISA are also exempt from capital gains tax. These tax advantages make the ISA wrapper valuable to most individuals.

It is important to remember that the ISA is simply a wrapper that protects whatever is held inside the ISA from tax – what assets you hold inside the wrapper will determine the returns achieved. You can either hold cash (within a Cash ISA) or investment funds, individual equities, or bonds (within a Stocks & Shares ISA). Anyone aged 18-39 can hold a Lifetime ISA. This ISA can only be used to fund the purchase of a home for a first-time buyer or be used for retirement savings, and this ISA has an annual limit of £4,000.

Cash certainly isn’t king

Possibly out of habit, many will choose to fund an ISA with cash, either through an instant access account, or a fixed term notice account. Cash has been a poor investment choice for some time, due to low interest rates generally, which have existed for over 12 years; however, with inflation rising, the real return (that is to say the interest earned less the prevailing rate of inflation) is becoming more deeply negative than at any time for a generation.

We all need to hold part of our wealth as cash, as it is only sensible to hold funds that are available to pay for living expenses and any unexpected expenditure. However, holding high balances on cash will almost certainly lead to the value of the savings eroding in real terms, and it would be worthwhile to consider alternative assets for balances held in Cash ISAs.

Dividend tax increase

From 6^th April 2022, the rate of tax paid on dividends paid by shares and equities based funds is increasing by 1.25% across all bands, with the increased tax take being used to support the NHS, health and social care. For basic rate taxpayers, the dividend tax rate will increase from 7.5% to 8.75%, with corresponding increases for higher rate taxpayers (from 32.5% to 33.75%) and additional rate taxpayers (from 38.1% to 39.35%).

The dividend allowance remains in place, whereby the first £2,000 of dividends received by an individual in a tax year are received tax-free. However, with dividend tax rates increasing, those with larger investment portfolios may wish to look at holding investments within an ISA to receive dividend income without tax being deducted.

Pension allowances frozen

Whilst pension annual allowances remain frozen for the 2022/2023 tax year, they remain highly tax-efficient vehicles for retirement savings. The maximum an individual can contribute is £40,000 in a tax year, or 100% of their earnings, whichever is the greater. However, the rules are complex if you are a higher earner, and it is always best to discuss contribution levels with an independent financial adviser.

We argue making sure that pension investments work hard for you is as important as funding the pension with regular contributions. With the new set of allowances available, it may be wise to review existing pension arrangements to ensure that the underlying pension funds are performing well, and undertaking a review of the overall strategy to make sure this continues to meet your needs and objectives.

Gifting

The new tax year heralds a fresh annual gift exemption, which remains stubbornly fixed at £3,000. Sadly, this allowance has not been reviewed for many years, and the available allowance does little to help individuals make significant headway in reducing the value of their potential estates which may be subject to inheritance tax.

Under the gift exemption you can give away assets or cash up to a total of £3,000 in a tax year without it being added to the value of your estate for inheritance tax purposes. If you haven’t used the allowance for the last tax year, this can be carried forward to be used in this tax year. In addition, small gifts of up to £250 can also be made, and separate limits apply to wedding gifts.

There are many options open to those who are concerned their estates will breach the inheritance tax limits, and we recommend seeking independent advice in this area. Here at FAS, we can consider options and solutions from across the market to help clients mitigate their potential inheritance tax liabilities.

Venturing out

Venture capital trusts (VCTs) are another planning tool that may be appropriate for those that expect high income tax liabilities in the new tax year. VCTs invest in smaller and unquoted companies and as a result, these tend to be higher risk investments; however, they do offer valuable tax advantages, with 30% income tax relief provided on qualifying investments that are held for a minimum of five years, and tax free dividends. This is, again, a specialised area, and one where our experienced advisers can provide expert advice.

Summary

The new tax year provides the ideal opportunity to spring clean finances, make use of newly available allowances, and review existing arrangements. If you feel that your finances could benefit from a thorough review, then please speak to our financial planning team.

If you are interested in discussing the above with one of our experienced financial planners, please get in touch here.