The declining income from fixed interest investments is adding further concern for those who have also seen the erosion of capital value on their equity holdings.

These are two distinct situations, of course. For investors, even those in retirement, their equity investments are expected to appreciate over the longer term to provide a nest egg. Whereas the bond and deposit element of their savings is generating income for day-to-day living. Retirees typically want a regular income to supplement their superannuation and they also want a sizeable emergency fund to pay for unexpected costs like medical bills. The current environment of low inflation and low growth in many parts of the world translates into poor performing share markets and rates of interest that are historically low. People are getting lower returns than they expected on their investments, but of greater concern possibly is the decline in their income levels.

Generally, the prime purpose of a fixed interest portfolio is to provide a secure income stream, particularly for clients in retirement. Retirees who can realistically expect to live at least another 15 to 20 years, must keep some of their investments in higher return assets that will grow over time. This is the money they’ll be drawing on in 10 years’ time. The majority of the money should be held in a variety of fixed interest issues, with some set aside in an emergency fund like a savings account such as Superbank.

At a time when the dividend yield on some shares is outstripping the interest on fixed term deposits and government bonds, financial planners need to be vigilant in making sure their clients are appropriately positioned to benefit from this. The adviser should certainly not be locking clients’ money up now in low interest bearing securities when interest rates are historically low.

Managing the income elements of a client’s portfolio is a key part of the service offered by adviser firm Direct Broking. David Speight explains that he tries to keep it simple for clients and help them avoid the pitfalls: “If we are talking about a low risk bond portfolio, we look at the range of maturities and try to ensure that these are evenly spread over say a five year term. So clients are not making any big macro decisions about the course of interest rates. We are taking away the worry about whether interest rates are going down further in the short term by averaging out their interest return over a reasonable time period. You won’t be getting the lowest rate and you won’t always be getting the top rates either, but over time you will get more of a steady income stream.”

As we know, each client has a slightly different objective, but most have one thing in common; they overestimate their own risk-tolerance. Even within the confines of a bond portfolio, it’s important to establish the right level of exposure for their needs from the start and for the client to be careful not to overestimate potential returns.

Direct Broking is happy to put clients into the handful of capital notes that carry a reasonable credit rating. “We look out for securities that have features that suit the interest rate environment”. For example, the perpetual note from Fonterra, which carries a credit rating of A+, has a current coupon of 7.48%, at a cost of $107.50 per $100. The rate is reviewed annually (next review due 10 July) and is set at 170 basis points over government stock. Therefore the investor benefits as interest rates rise.

ASB redeemable preference shares (credit rating A-), with a current coupon of 7.4% reset annually at 130 bp over a 1 year swap provide the same features. In both cases the minimum investment is $5,000. And in the current environment, they offer a better interest rate than term deposits or 4-5 year government bonds.

Looking around for alternatives to boost your income, the problem for NZ investors is that there isn’t much in the way of middle tier credits (BBB type), which means there is a gap between the bonds paying 5.5% and capital notes paying 8-10%. Speight says: “While this is of concern, there are now a large number of different issuers in the capital note market and therefore investors can reduce risk by diversifying. Investors do get a higher rate for investing in capital notes and, to date, New Zealand default history in the capital note market (the last default was Skellerup) suggests investors are getting rewarded for the additional risk. Although each new issue needs to be looked at on its own merits.”

The greatest risk when rates are declining is for the client to move too far up the risk scale in search of a higher income. Investors do need to be aware of the risks involved in moving into some of higher yield capital note issues. Speight says he tries to explain to his clients the concept of sub-ordinated debt, and looks to limit the amount held in any one investment to 5-10% of the fixed interest portfolio and lower for some capital notes.

Nonetheless, it is of some concern that high yielding investments such as debentures and mortgages are attracting many unwary investors. There isn’t enough understanding of the differences between an investment paying 7% and one paying upwards of 9% and as these higher interest offerings become more popular, there is a risk that investors, many in retirement, will lose money. Fund managers and advisers are beginning to express their own concerns that clients, stressed out by ‘losses’ on the stock market are chasing high yields to compensate. Gareth Morgan is among those to highlight the problem. His criticism is at the unsecured capital note market, where companies are offering attractive returns to investors who are desperate to generate positive returns: “Surely we are seeing some of these investors manoeuvre themselves into a position where the risk they’re exposing their capital to is soaring. There are going to be some casualties.”

It is wrong to assume that issues that carry a higher headline interest rate are dramatically more high risk. Some are, of course, but if you study the fixed interest schedule of the major stock and bond brokers, you will see clearly that for bonds with ratings down to BBB- there are attractive rates available, up to around 8% currently. Anything above that and the issue is unlikely to carry a credit rating, which puts it in the junk category, in spite of the fact that the issuer may be a well-known and well capitalised New Zealand company such as GPG or Fletcher Building.

It has become clear from recent media coverage that investors in un-rated debt securities are getting a raw deal compared to investors in the US. The mis-pricing of junk issues illustrates that investors are not getting a return commensurate with the risk they are taking. In some cases, the shortfall is as much as 4% interest.

In managing credit risk, an adviser needs to consider how much debt relative to equity an issuer carries in its balance sheet, how much senior debt may rank above its paper, its cash flows and its interest cover (how many times its earnings will cover its interest costs). The do it yourself portfolio builder needs to consider interest rate risk, the direction or trend for rates and credit risk, the likelihood that the issuer will default. The last factor is largely determined by reference to the credit rating of the bond issue or, more accurately, the issuer.

You can get capital gains from both bond markets (from falling yields) and equity markets at the same time. One of the other key attractions at the moment is that there is the opportunity of reasonable positive returns due to the relatively low level of shares and the improving dividend yields. For investors in the New Zealand market, one of the most effective ways of managing your portfolio to boost the income element is to skew your share portfolio towards the high dividend shares. And if we look at the international share markets, European stocks are offering attractive yields too. For instance the average dividend yield of the European stocks in the portfolio Templeton runs for the Bank of New Zealand is 5.4%. One quarter of the portfolio has a dividend yield higher than you could get from a bank. And for the first time since 1959, the dividend yield on the UK equity market is nearly higher than the yield from the bond market.

So you can see why it’s important to key a close eye on interest rate trends and be open to the opportunities available for boosting income levels.

Copyright 2003 Richard Newell


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