Where for art thou Yield?
Key Points:
– Holding cash for the long term has very little reward. – Interest rates are expected to be “lower for longer” due to high global indebtedness. – Long term interest rates have risen modestly reflecting some global recovery since the GFC. Further rate rises are expected to be modest. – Conservative investors, and those requiring income in particular, should consider a diversified exposure to fixed interest strategies to generate a defensive income stream.
Yield for a conservative investor seems elusive. The current reality is that it is a low return world we live in and this outlook doesn’t look like changing for the next few years. Now that’s out of the way, let’s see where you can go for something better than cash and stay defensive. Investors in search of a secure yield have been stymied for some years as the domestic official cash rate has been progressively cut to its current level of 1.5% (and lower in the rest of the developed world). That’s not much for those investors looking to live off a “risk free” rate of return. Looking longer term, the Australian 10 year government bond rate is around 2.7% and the US 10 year government bond rate is 2.3% – little more than inflation at best.
In reality, deposit taking institutions are rarely offering even the official cash rate over the counter but are directing customers to online banking and term deposit products which tend to offer rates up to around 2.8%. Hardly anything to get excited about but that is our starting point.
Our expectation is that the deposit taking institutions of this country will continue to tell us their funding costs are rising for a range of reasons and, whilst they pass this on to various borrowers, deposit holders may not get a look in. And don’t expect the RBA to help out either – in the absence of rising wages or inflation, alongside record levels of household debt, there is little incentive for the RBA to move interest rates north. In the meantime the lenders are doing their job for them, ahead of time!
If cash and term deposit rates are sub 3%, hardly enough to cover inflation, you have to look beyond the banks for defensive yield as an investment.
Investing beyond cash into fixed interest investments can be daunting. Australians are generally familiar with shares but not so much with fixed interest. Even the term fixed interest is inaccurate given these investments often pay income that is anything but fixed. The category includes many different types of investment instruments including:
– Hybrid securities – Government and semi government bonds – Corporate bonds – Inflation linked bonds – Asset backed securities – Collateralised loan obligations – Collateralised debt obligations – Credit – High yield – Senior secured loans
Some of the main aspects to consider in portfolio selection include credit duration, time to maturity, credit spreads, credit ratings, fixed or floating rates and inflation. Each of these elements can impact the current market price of a security and presents a dimension of risk.
So how to go about it? Much the same way as you would with an equity portfolio – diversification across many holdings and a sober assessment of return potential versus risks. Remember, the best result you can expect when someone borrows your money (and that’s the upshot of the above securities) is getting all your interest paid and your capital returned, so we’re going to say it again – DIVERSIFY.
Be wary of chasing high yielding fixed interest portfolios! If you look to a more exotic debt strategy, you may also generate capital growth (or loss) from sophisticated trading strategies but investors should be conscious of the risk/s they are taking.
One important benefit of government bonds in a portfolio is that they often rise in value when share markets fall abruptly. This isn’t always the case but more often than not does tend to happen in low interest rate environments like now.
In constructing portfolios, Sovereign Wealth Partners consider each client’s risk tolerance, risk capacity and risk required to achieve their wealth objectives. In the defensive part of a client’s portfolio we tend to look to more secure forms of fixed interest, targeting a modest return over cash over the medium and long term. Where justified, we also seek higher yielding debt strategies and add these to the client’s “growth” part of the portfolio allocation (reflecting the risk we believe is potentially inherent in these strategies).
It’s also important to understand the strategy of a fixed interest manager. They may be (and the list is not exhaustive):
– Global or domestic – Passive (index manager) – Benchmark aware (taking active positions around the index) – Highly active (only investing in parts of the market where opportunity is identified) – Corporate or credit only
Each has their pros and cons. Blending (diversification) is often the most productive approach for portfolios.
So what can you expect? You can expect a yield in the form of interest payments. But you can also expect your investment value to move, reflecting movement in interest rates and market conditions.
Broadly, there are three environments:
– Interest rates steady – you can expect a steady yield and your capital to remain stable – Interest rates falling – your yield will decline over a period and your capital may increase in value – Interest rates rising – your yield will rise over a period and your capital may decrease in value
Investors should always consider the purpose and value of fixed interest in their portfolio over an entire interest rate cycle, not just the next 12 months. One current concern for investors is the potential for a sharp unexpected rise in interest rates. This could happen if inflation started to break out and central banks reacted aggressively. However this is not our current outlook. As one manager consistently points out, “The world is too indebted. High debt and high interest rates are not natural bedfellows”. This is not to say interest rates won’t rise but the rises are not expected to be much.
We can’t say what different fixed income funds and strategies will earn over the coming year but the table below illustrates some fund types, their yields for the year to 30 June 2017 and their total returns (incorporating capital movements as well).
After a period of strong returns, index funds have struggled over the last year as long term bond rates have risen. Of course, past returns are not a reliable indicator of future returns.
The lasting message is that for many investors bonds have a place in portfolios over the full interest rate cycle. Well managed, they should pay a yield and deliver total returns which are meaningfully higher than cash over the long term. They may also reduce equity risk in a portfolio.
Disclosure Statement: This communication has been approved and issued by Sovereign Wealth Partners Pty Ltd ABN 18 607 071 367 Corporate Authorised Representative (No. 001233909) of Bennelong Wealth Partners Pty Ltd ABN 44 164 127 833, AFSL 456235.
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