Investing in a low interest environment
How much risk are you taking for your yield?
The collapse of 67 finance companies between 2006 and 2012, with a corresponding loss of $3 billion, should forever serve as a reminder to investors about the risks of chasing yield. But in the current low interest environment, this temptation could once again rear its ugly head.
After a period of stable interest rates, the Reserve Bank of New Zealand recently cut the Official Cash Rate to a record low. The yields on government and corporate bonds have also reached all-time lows and have fallen dramatically over the last 6 months. Yields could still fall further if a recession were to hit our shores. We have seen zero and negative interest rates in other countries, and this is the current situation in most of Europe and Japan.
“New Zealand and Australia are finally catching up to the rest of the world in the race to zero” says QuayStreet Asset Management senior analyst Roy Cross, and it may come as a shock to many investors who have never seen interest rates this low.
For those investors that require a certain level of return, this is a difficult choice. Accepting a lower level of investment income may require some drawdown of capital, which could impact longer term investment goals. Alternatively, investing more in higher yielding assets could result in even larger capital losses if not done sensibly.
There are advantages and disadvantages of every investment, whether it be shares, bonds or savings in the bank. The question should not be "which one should I put my money into" but rather – "how much should I allocate to each?”
Investing in shares for income
Investing in shares has been a successful strategy in New Zealand recently. The market has a high proportion of companies in relatively low risk sectors, such as listed property, infrastructure and utilities. We have seen NZX listed companies in certain sectors sustain higher dividend payouts. However, dividend payments are not the same as interest payments. Dividends can be reduced or cut completely at the whim of the company and there is also the risk of capital losses if share markets fall.
Bonds no longer the low risk option they used to be
Interest rates have fallen so much that there is very little benefit in investing in bonds compared to savings and term deposits. This means that investors are being forced to invest in longer dated maturities or less credit-worthy issuers to pick up extra yield. As Roy points out, you can chase yield by buying longer dated securities “but you only need a small upward movement in interest rates or credit spreads and you can have a negative return.” And as interest rates get closer to zero, the potential to make capital losses increases.
While New Zealand bonds tend to be in the low risk category, Roy says people need to understand that the potential returns can vary. If the bond is held until maturity, the maximum return is the yield, while the maximum loss is 100 per cent if the issuer defaults. “You only need one to go wrong and your whole portfolio is off track.”
What about term deposits?
Term deposits have always been an attractive option for retail investors in New Zealand, and in the current environment, interest rates are very competitive. There are also no management fees or trading costs and you know exactly the return you are going to get. “However it is unlikely that term deposits alone are going to provide a sufficient level of return to protect against inflation and provide an income stream. There is also the drawback of the investment being locked up until maturity and managing the reinvestment risk when deposits do mature” explains Roy.
Could managed funds be the answer?
Managed funds are one potential solution that can incorporate all of the above but the allocation between investments is actively managed and constantly monitored. These funds can provide a higher return than traditional cash or bonds while maintaining a conservative risk profile. One example is the QuayStreet Income Fund, run by a team of investment professionals who have worked together for more than a decade; their active management approach is founded on a strict risk management framework. In the current environment, Roy says that understanding investment risk is “far more important” than the returns that may have been delivered in the past.
An income fund, designed to deliver regular income
The Income Fund invests in a range of different securities including cash, term deposits, bonds and shares and has the ability to invest in international markets. Each investment in the Fund is considered on its merits and this approach is consistent when considering equities, bonds or deposits.
“We draw on our experience when deciding how and which investments we add to the Fund” says Roy.
The key features of the Fund include an emphasis on income - producing assets, aiming for quarterly distributions, easy access to capital with daily liquidity, and no entry or exit fees. Established in 2014, it has a strong performance track record and is currently the second best performing managed fund in its segment according to Fundsource*, with a five star rating.
The QuayStreet Income Fund
Example of how investors could use the Income Fund to target higher returns
John and Jane had investments in savings, term deposits, bonds and shares. They had been receiving reasonable levels of income from all of their investments but this has fallen off significantly in the last few years. After assessing a variety of options, they decided to invest in the QuayStreet Income Fund.
They were aware that this approach required taking some more risk but the QuayStreet Income Fund was a good way of diversifying across assets and issuers, with an emphasis on income-producing assets, rather than investing more into shares or other alternatives.
- Potential to earn a higher return than cash, term deposits or bonds
- Potential for regular distributions of income and access to funds if required
- High level of diversification - investments are spread across different assets and issuers.
- Higher risk of capital losses than original mix
- May still not provide a high enough return to meet investment goals.