With cash savings rates approaching 5% if you’re prepared to lock your money away for a few years, investors are starting to ask if this is a better place for their savings than taking the risk of investing in the stock market.

Over the past decade or so, income funds have been popular investments as they’ve offered more generous yields than you’d get on cash. Now the Bank of England’s base rate has jumped to 2.25% and is expected to go a lot higher, banks and building societies are able to offer much better rates on their savings accounts.

At the time of writing, the top rate on an easy access savings account was 2.8%, you can get 4.6% on a one-year fixed rate account, 4.8% on a two-year fixed rate and 5.05% on a four-year fixed rate, according to Moneyfacts.

The average dividend yield on investment trusts in the AIC’s UK equity income sector is 4.4%, although quite a few pay more than 6%. Income funds and investment trusts come with the risk that the companies or other assets in their portfolio fall in value and the dividends aren’t guaranteed unlike the interest payments on cash.

On this basis you might think cash is now king. However, there are good reasons to still have exposure to income-paying investments.

Crucially, the investment route typically has the added attraction of dividend growth. With a fixed-rate cash account the rate of interest doesn’t change, but you could easily see 5% dividend growth each year with an income fund. There is also the added potential for the capital value of the income fund to also grow.

Buying an income fund helps to spread the risks and so you don’t feel the pain as much if something bad goes wrong with one holding in the portfolio versus owning that stock outright.

Over the long term, shares have proven to outperform bonds and the return derived from cash. Adjusted for inflation, over the past 50 years UK equities have generated an average 4.9% annual return versus 0.9% from cash, according to the 2022 Barclays Equity Gilt Study.

You don’t need to choose one or the other. The current market sell-off has taught us the benefit of diversification and so having some of your assets in cash and some in investments is not a bad thing now that cash rates are much more attractive.

To explore the topic further, we spoke to a range of fund mangers to get their thoughts on the cash versus investments debate.

INCOME MANAGERS HAVE THEIR SAY

Simon Gergel manages The Merchants Trust (MRCH), a UK equity income investment trust with a key focus on paying a high and rising dividend that offers an attractive yield of 5.4%.

Merchants Trust has raised its dividend each year for 40 years in a row. It recognises the importance of providing a steady income as well as the compounding effects of reinvesting income into more shares.

Gergel won’t advise investors on whether they should invest in cash or not. However, he points out that following year-to-date weakness, the UK stock market’s valuation is ‘very reasonable’ from a long-term perspective, with the UK trading at a large discount to many other major markets despite most UK-listed companies’ sales and profits come from overseas.

The fund manager adds that as well as low aggregate valuation, there is ‘a considerable variation in valuations’ in the UK market. This is enabling Gergel to identify many good quality companies trading significantly below his view of their fair value.

He adds: ‘We believe that by buying a portfolio of these companies, investors can receive both an attractive dividend yield, in the short term, and the prospects of good total returns in the medium term.’ The term total return refers to the gains or losses on the capital value of your investment and dividends on top.

Gergel says this is an environment where ‘stock picking can give an advantage as the dispersion of valuations is so high, and economic conditions are uncertain and subject to change’.

EQUITIES WON DURING TIMES OF HIGH INFLATION IN THE 1970S

Also weighing in on the cash or income fund debate is Ben Peters, manager of Evenlode Global Income (BF1QNC4), a fund which focuses on sustainable real dividend growth and invests in companies with high returns on capital and strong free cash flow.

Passing muster with Peters and populating the global fund are pricing power exemplars such as PepsiCo (PEP:NASDAQ), Nestle (NESN:SWX) and LVMH (LVMH:BIT), while other holdings include Dutch information services group Wolters Kluwer (WKL:AMS) and credit reference agency Experian (EXPN).

‘It is certainly the case that rates on cash and fixed income have got more interesting over recent months,’ concedes Peters, ‘but that has come from a very historically low rate.’

He explains that when you invest in a company, you get ‘a business that’s operating in the real world and that company’s operations can cope with lots of different economic situations’ including inflationary environments.

‘If you look at the return on equities through the 1970s, when there was persistently high inflation, you got a positive real return from equities,’ points out Peters. ‘It wasn’t huge, but it was a positive real return. Being in cash or
cash-like instruments, you would have seen a real degradation in your purchasing power. Investing in shares maintained that purchasing power.’

Peters concedes that equities are volatile as an asset class, yet his view is if you have savings that you are ‘willing to invest for a period of many years, then shares have proved themselves to be a good place to be’.

MORE SUSTAINABLE DIVIDENDS

Simon Murphy manages VT Tyndall Real Income (BYX0D83), invested in the likes of inter-dealer broker TP Icap (TCAP), packaging firm DS Smith (SMDS) and insurer Prudential (PRU). While cash looks more attractive than it has been for some time, Murphy argues dividend yields on equities, particularly in the UK, ‘continue to look appealing’ with the historic yield on the FTSE All-Share currently circa 3.8%.

Murphy makes the point that following the painful dividend cuts suffered during the pandemic, the overall market dividend yield looks ‘significantly more sustainable now than previously’.

If you believe we have entered a period of significantly higher inflation, ‘then company earnings, and subsequently dividends, ought to grow, possibly significantly, helping to protect against inflation,’ argues the fund manager.

Though the FTSE’s headline historic yield is 3.8%, Murphy says there are many high-quality UK companies with dividend yields well above this level. VT Tyndall Real Income Fund has a historic yield of 4.8% and the manager is optimistic on the outlook for dividend growth from its current portfolio of companies.

Should I choose equities or bonds for income?

‘For years the argument has been that the lack of yield in other capital markets has meant income funds are attractive,’ says James Harries, manager of Securities Trust of Scotland (STS). ‘We would argue the opposite.

‘Yields have risen because inflation has reappeared, leading to a far less favourable policy backdrop. For years interest rates were held low and quantitative easing pursued to stimulate consumption and activity. This was fine while inflation was subdued. As this is no longer the case, policy is focused on quashing inflation rather than bolstering asset prices. Essentially the needs of the real economy are rightly being prioritised over the financial economy.’

Harries continues: ‘That this is happening at a time when valuations in equity markets remain elevated relative to history means that returns are likely to be lower than in recent times.

‘When returns are plentiful the relative certainty of an income yield becomes overlooked by investors. But for those with irreplaceable capital and in need of growing income to pay increasing day-to-day bills, without having to dip into capital at times of stress, a balance between income and capital growth is more important than ever.

‘Indeed, given the substantial gains enjoyed by equity investors since 2008, despite recent losses, we still think it is not too late to take some of those exceptional gains and secure an attractive, dependable, growing long-term income stream.’

Harries says the rise in bond yields does not invalidate this argument. ‘It does give investors an opportunity to enhance the income they can generate from their assets alongside that derived from equities. We would argue that for the first time in years the conservative, income seeking investor is able to benefit from both fixed income and equity income investment.’

He concludes: ‘A certain income from bonds and growing income from equities. This balance is something that has been denied investors for the last 14 years and should be seen as an anomaly. Its return is most welcome. For income investors it’s not either/or therefore but both.’ [JC]

DIVERSIFY YOUR INCOME STREAMS

Another attraction income funds have over cash is they enable you to diversify income sources by geography and assets. One example is TB Wise Multi-Asset Income (B0LJ016), a diversified fund with the flexibility to invest in all asset classes. Equities, alternatives, property, fixed interest and cash are all part of the mix.

Co-managed by Philip Matthews with a value bias, the fund targets a consistent and attractive level of income. Equity holdings include quarterly dividend paying trust TwentyFour Income Fund (TFIF), as well as Ediston Property (EPIC) and Empiric Student Property (ESP).

Entering 2022, Matthews says it was ‘incredibly difficult’ to construct any sort of multi-asset income fund ‘because yields across the board had just fallen to such a large extent’. Any income going begging was in ‘the risk assets rather than the risk-free asset part of the market’. He adds: ‘People talk about “risk-free return” becoming “return-free risk”, and that’s kind of where we were at the start of the year.’

Reasons why you shouldn’t abandon shares completely in favour of cash

- Potential for annual dividend growth

- Potential for capital gains

- Many UK stocks are cheap

- History shows that shares have beaten cash over the long term

With inflation back and interest rates rising, Matthews says investors can now construct a much more attractive portfolio of income with more breadth in the portfolio than historically. He has added a ‘fair amount’ of fixed income to the fund in the past two months and says the positive is you’ve got a risk-free rate that has moved up and credit spreads widening, so risk across the spectrum seems to be better priced.

Funds also enable investors to put money to work across the market cap spectrum and one exemplar is Unicorn UK Income (B00Z1R8). Co-manager Fraser Mackersie insists multi-
cap income funds offer ‘very attractive dividend yields, with strong capital recovery potential’.

He flags that Unicorn UK Income has just paid a record annual dividend per share for its September financial year-end with the dividend per share now back above pre-pandemic levels. The current 6% yield is towards the top end of historic range and is significantly higher than large cap dominated FTSE All-Share yield, and the fund has seen ‘a strong dividend recovery and the underperformance of small and mid-caps has pushed yield higher’.

DISCLAIMER: Editor Daniel Coatsworth has a personal investment in Evenlode Global Income referenced in this article

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