Following the huge impact of the Covid-19 pandemic, the Bank of England cut interest rates twice in quick succession. This means that the base rate here in the UK is just 0.1%. Given the size of the disruption the pandemic is causing (just look at the slump in the FTSE 100 index), rates are unlikely to be raised any time soon.
As investors, we need to find other ways to make our money work for us. Leaving our money in a Cash ISA or some other form of savings account is just not going to cut it. In order for the money to generate income, we are going to have to take on some added risk in order to get a greater reward.
What rate of interest are we looking for? Everyone is different, so there is no one answer here. However, the latest reading of inflation came out at 1.7%. This means we need to generate at least 1.7% in interest just to stop the value of our money being eroded by inflation. Anything above that becomes real yield, which is what we want.
How stocks can help with low interest rates
Most businesses within the FTSE 100 pay dividends. This has given rise to a common financial ratio of a dividend yield. This seeks to compare the size of the dividend with the share price of the firm. When you see what proportion of the share price is paid as a dividend, you can obtain a percentage value. You can then use this almost as a proxy for an interest rate.
Let us take an example. One of the largest firms in the FTSE 100 index is GlazoSmithKline. It currently has a dividend yield of 5.18%. While this isn’t officially an interest rate, we can use it as a fair comparison. How does it compare to other income-paying assets? Well, we have already seen above that interest rates are 0.1%, so it beats savings accounts easily. Bonds pay a coupon, which is classified as income. Yet the yield on a generic UK Government bond is only around 0.5%. So again, a dividend-paying stock offers a substantially higher income for an investor.
Higher income, higher risk?
One point investors should note is that receiving income from a dividend-paying stock does come with higher risk than a Cash ISA or bond. This is because dividends can be cut or reduced, depending on company performance. ITV is an example of this, recently cutting the dividend in response to the virus.
Further, there is volatility in the underlying share price of the firm whose shares you buy. While you lock in the dividend yield with the price you paid for the share initially, this price does change. Yet even with the higher risk, I still feel dividend-paying stocks are the best way to get income at the moment. This is because the dividend yield is so much higher than other assets.
I would take a 5.18% yield from GlaxoSmithKline, and stomach the potential movements in the share price and risk of a dividend cut. There are other companies whose dividends appears to be safe, and have low volatility, such as Imperial Brands, Taylor Wimpey and M&G. Check out my Motley Fool colleague Roland Head’s view of their dividends here.
