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UK investors looking for passive income can get up to 5% a year by leaving their money in cash. But with interest rates set to fall, I’m not convinced this is a particularly good idea.
Even with savings accounts offering some attractive rates, I think income investors should focus on the stock market. Especially shares in companies that return cash to investors as dividends.
Saving and investing
Getting 5% a year creates a strong temptation for investors. With £20,000, there’s the opportunity to leave the money in cash and collect £83 per month in interest.
That situation, however, is unlikely to last forever. It looks as though interest rates are set to fall and cash savings will generate lower returns when this happens.
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Given this, one strategy is to hold on to cash while the returns are good and look to move into stocks and shares when interest rates fall. On the face of it, this makes a lot of sense.
Unfortunately, this attractive-looking plan has a fundamental flaw. It fails to account for the fact that dividend stocks are also sensitive to changes in interest rates.
The stock market
When interest rates fall, share prices generally go higher. That’s because lower returns from cash and bonds make equities more attractive, causing investors to buy.
The trouble is, higher share prices mean lower dividend yields. So anyone looking at – for example – Segro (LSE:SGRO) with a 4.75% yield today might well find it isn’t there when interest rates fall.
In general, low interest rates can be very positive for businesses. And it’s especially true for real estate investment trusts (REITs) like Segro.
REITs can’t retain their earnings, meaning they have to either take on debt or issue equity to grow. And falling interest rates mean borrowing costs are lower, creating more opportunities.
Warehouses
Segro owns a portfolio of warehouses and industrial distribution facilities. It leases these to tenants and distributes the income to shareholders as dividends.
The risk with this type of business is the potential for oversupply. The rise of e-commerce has led to a boom in warehouse-building in the UK and that’s generally not a good thing for rents.
Segro, however, focuses on properties in locations near major cities and transport hubs. Space in these areas is limited and this typically means strong demand.
Around 95% of the firm’s portfolio is currently occupied. And the company has consistently managed to increase its dividend over time.
Buying shares
Income investors have a choice – they always do. Cash currently generates a 5% return with almost no risk of capital loss, but that return is likely to go down if interest rates fall.
At the same time, shares in companies like Segro offer a 4.75% dividend yield. And that return looks set to increase if the firm keeps returning more cash to shareholders.
If investors wait for interest rates to fall, though, they might well find themselves faced with lower starting yields. So I think the right strategy is to consider buying stocks like Segro before this happens.
