UK 30-year government bonds currently come with a 5.38% yield. With the FTSE 100 offering a dividend yield of 3.36%, that could be interesting for investors looking for long-term passive income.
While bonds are relatively low-risk investments (the chances of the UK government not paying its debts are pretty remote) there’s a catch. The annual return can’t go up over time – and that’s a concern.
Inflation
At today’s prices, a £10,000 investment in 30-year UK government bonds is set to return £538 per year. For context, this is around eight times what investors could have earned five years ago.
Source: Trading Economics
One issue with bonds, however, is inflation. And there are a couple of reasons why this is important.
The first is that rising prices typically result in higher interest rates, which cause the value of long-term bonds to fall. So if rates rise, today’s 30-year bond might be worth less in the future.
From an income perspective, this is the smaller issue. Whatever happens in the markets, the bond matures after 30 years and – barring something extreme – investors get their money back.
The bigger issue is the effect on real returns. Over the last three decades, the UK Consumer Price Index (CPI) has increased by 145.7%, which implies an inflation rate of just over 3% per year.
If that continues, it could seriously cut into real returns over the next 30 years. Put simply, getting £538 in 2055 would be like getting £219 today – and that’s an issue for passive income investors.
The stock market
An alternative approach to passive income involves the stock market. That allows investors to buy ownership stakes in companies and receive a share of the profits in the form of dividends.
The obvious risk with this is that earnings are much more likely to go down than bonds. But with the best businesses, there’s also a chance their net income rises faster than inflation.
Unilever (LSE:ULVR) is a good example. Over the last decade, the firm’s dividend growth has outpaced the CPI, leading to better results for investors, even accounting for inflation.
There is, however, no guarantee of this continuing. One of the risks with Unilever is that it’s easy for people to change to other products, meaning a constant battle to stay ahead of competitors.
The company, however, has two key strengths when it comes to meeting this challenge. The first is its brand portfolio, which customers recognise and trust.
The second is the firm’s vast scale, which allows it to negotiate preferential terms with suppliers and retailers. Together, these make a powerful long-term combination.
Locking in
Unusually high bond yields offer an unusually high passive income return that’s very unlikely to disappear in the next three decades. But investors should be careful about locking this in.
With a return that can’t go up, inflation is a big risk over the long term. By contrast, businesses can – when things go well – increase their dividends over time to offset this threat.
Unilever shares have a 3.5% dividend, which is below the 30-year bond. But with scope to grow as inflation cuts into gilt returns, I think investors should consider the stock over the bond.
