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Right now, UK investors have a chance to turn £20,000 into £1,094 a year for the next 30 years. And that return is about as close as it gets to guaranteed when it comes to passive income.
30-year gilts – bonds issued by the UK government – have a 5.47% yield and are very low-risk. There’s a lot to like, but I think investors looking for extra income should aim to do better with a Stocks and Shares ISA.
Gilts
Gilts offer a straightforward way of earning passive income. They pay a fixed return each year until they mature unless the UK government goes broke, which seems unlikely.
To say the current yield is unusually high is an understatement. The last time investors were able to get this type of return from a 30-year gilt was May 1998.
It’s definitely fair to say that opportunities like this don’t come around every year – or even every decade. But while the threat of a default is low, there are other important risks to consider.
The big issue is inflation, which is a risk for assets that provide fixed returns. Over the next 30 years, the cost of living is likely to go up, but gilt returns won’t increase to offset this.
If inflation averages 2.5% per year over the next three decades, £1,094 will buy about half as much stuff in 2055 as it does today. That’s a problem for investors seeking long-term returns.
To offset this, investors need to think about assets that can generate more income over time. And dividend stocks could be a good example.
Dividend stocks
Water utility Severn Trent (LSE:SVT) is an interesting dividend stock. The current yield is 4.5%, but it’s worth noting that the firm’s distributions have risen by 3.6% a year over the last decade.
That’s more than enough to offset the effects of inflation, but the stock isn’t exactly popular with investors. And with a high debt level and a rising share count, it’s easy to see why.
These are the results of various investments in infrastructure. But while the amount Severn Trent is allowed to charge customers is regulated, it does include a return on these expenses.
The allowed rate of return is reviewed by Ofwat every five years and the real risk is that it might be decreased at the next review in 2030. And there isn’t much the company can do about this.
Ultimately though, disincentivising investments in water infrastructure isn’t really in anyone’s interest. It eventually leads to bigger problems, which results in higher bills for customers.
Regulation is a genuine risk for Severn Trent. But I don’t think it’s one that investors – especially those looking for passive income – should see as an automatic deal-breaker.
Long-term income
Turning £20,000 into £1,094 per year for 30 years by buying bonds doesn’t seem like a bad idea. And in some ways it isn’t – it’s a long time since that kind of return was available.
Over time however, the effects of inflation are a big concern. So I think investors looking at gilts should consider buying stocks like Severn Trent instead.
The starting yield is lower. But the long-term effects of inflation on the bond returns and the potential for dividend growth means I think it’s a much more attractive option.
