By: BILL BLEVINS
Financial Correspondent, Blevins Franks
If taxation didn’t exist, we would all be much richer. Just consider how much income tax you’ve paid over your life, both on your salary and savings. Not to mention capital gains tax and a whole array of other taxes.
For example, if you added up the amount of VAT you’ve paid through the years, the result would be astounding. There is nothing you can do to avoid VAT, but you could restructure your savings to receive tax efficient income.
Tax significantly lowers the amount you have to live on each month and save for the future, thus affecting your long-term wealth. On top of tax, inflation also eats away at your income, reducing it further. For example, if your deposit account pays five per cent interest and your tax rate is 20 per cent, then you only receive four per cent interest in your pocket.
With inflation at around two per cent, your real income is only two per cent and your personal rate of inflation is likely to be higher than this.
To protect your long-term wealth, you need to consider both your income and your capital. The rise in the cost of living each and every year will significantly reduce the value of your capital. You need to give your capital the opportunity to grow (something which doesn’t happen with cash in the bank) so it keeps up with inflation – or even better, beats inflation, giving you more to spend in your later years.
It is well known that investing in equities is usually the best way to beat inflation. Over the long-term, equities produce the highest real returns. Another effective means of achieving long-term capital growth is to invest in a high yield bond fund, which works well alongside equities in a diversified portfolio or can replace equities altogether. Such bond funds have the added advantage of providing regular income, which is usually higher than that offered by banks and which can be protected from unnecessary taxation (unlike banks).
A bond fund, therefore, can help you beat the twin threats of inflation and taxation, and provide you with attractive income.
To compare the yield from bonds and cash we can look at the annual study carried out by Barclays Capital. Its recent study lists the annual real returns by asset class for 2005. Corporate bonds returned 9.8 per cent for the year and eight per cent over the 10 years to 2005. Gilts (UK government bonds) returned six per cent for the year and 5.7 per cent over 10 years. In comparison, cash only returned 2.7 per cent in 2005 and 2.8 per cent over 10 years.
Interest rates are higher today than they were in 2005, but so is inflation, so the real returns from cash today won’t necessarily be much higher than in 2005 and, in any case, the bank interest rate is likely to fall again in the years to come.
A well managed bond fund, on the other hand, is likely to continue paying a high interest rate, around 6.5 per cent; or 10 per cent or more total return, which is the yield plus growth.
Bond investment differs from equity investment in that you lend money to a company (for which they pay you regular interest) instead of buying a share in it. This difference means that bond investment is less risky than equity investment and you don’t get the volatility in the bond market that you do in the stock market. Bonds, therefore, play another key role in a diversified portfolio in helping to reduce the overall risk level.
Bonds offer different yields depending on who issues them. The low risk level of gilts means they offer a lower rate of return. Corporate bonds issued by established companies pay more than gilts but less than new companies, those looking to expand or those going through a down period. Bonds issued by this last group are called high yield bonds because of the high income they offer.
High yield bond funds specialise in selecting bonds to provide a high level of income and capital growth potential, at the same time as reducing risk. This is achieved through a strategic range of bonds, from gilts to high yield ones and from different sectors, countries and currencies.
You will receive a regular income, but it is also possible to reinvest your income in the fund to increase the capital growth. From a tax point of view, this is very attractive as it means that you can accumulate income and gains free of both income and capital gains tax.
The bonds in such funds are usually from ‘industrialised’ nations but you can also invest in global funds with a focus on emerging markets. Such bond funds offer increased potential for high returns. According to the International Monetary Fund, growth in emerging market economies has exceeded advanced economies over recent years and is expected to continue to be roughly double the growth of developed markets.
It is easy to place your bond fund within an insurance bond to reduce the amount of tax paid on income and capital gains.
Bonds can certainly be an aid in protecting your wealth. The tax efficient income and capital growth offered will help increase your income today and protect your capital from inflation to maintain its value right through your retirement.
Remember that the value of shares in a bond fund can go down as well as up.
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