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By Richard Newell, June 2003
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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Richard Newell. All rights reserved. |
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