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Investment Enews
August 2017

Investing for income

We often speak to investors at or near retirement age who are looking for reliable income streams on which they can live. There are a number of strategies that they are employing to achieve this objective. Unfortunately, we often find the common misconception that income-based investment is inherently low risk.

This edition of Investment Enews will explore some of the risks inherent in the most common income investment strategies. After all, it is critical that investors understand the risks, as well as the benefits, of each of the investments that they are choosing.

Cash & term deposit investments

Cash and term deposit investments have traditionally been seen as providing two key benefits: capital security and regular, reliable income streams. And, from a capital security point of view, cash has long delivered for Australian investors. However, it would be a mistake to regard this investment as absolutely ‘risk free’. You may recall in 2013 when the Bank of Cyprus announced customers would lose 47.5% of savings exceeding US$132,000. And in 2014 when former Harvard professor of economics, Terry Burnham, made headlines, when he announced that he was withdrawing $1,000,000 in deposits from the Bank of America because he was not being properly compensated for risk.

Of course, it almost goes without saying that the Australian banking system is currently in far better shape than the systems of Cyprus or the United States. But it would be naive in the extreme to argue that there is zero risk of a system-wide crisis that could put Australian deposits at risk. Even the government guarantee could be tested in extreme cases. The risk is that a system-wide crisis could overwhelm the effective ability of the Federal Government to protect depositors. That is why it is critical to ensure that any cash or term deposit investment generates sufficient yield to compensate for risk however small that you judge the risk to be.

This leads us to consider the second limb of the rationale for cash and term deposit investment, being regular, reliable income streams. And it is here that cash and term deposits are not currently performing for investors.

For some time the focus has been on the level of inflation given the rates of return earned on deposits. It is clear that in recent time investment yields on deposits have been contracting. In December 2016 the annual inflation rate was 1.30% while the RBA’s average retail deposit and investment rate for savings accounts and online savings accounts (holding $10,000) fell 0.05% to 1.25% meaning the average interest paid to Australian savers fell below the national rate of inflation. The last time this occurred was in June 2014 when the consumer price index was 3% and the average savings rates were just 2.50%. Things were not looking better in March this year when the annual inflation rate grew to 2.1%. Latest figures show that the annual inflation rate at June had contracted to 1.9% however, with the RBA target range of 2-3% for inflation, this only highlights the importance of the level of income required from savings that many Australians rely on.

The ‘nutshell conclusion’ for investors is that exposures to cash and term deposits have to be weighed and considered very carefully.

Bonds

The second income strategy that investors talk about is bond investment. Traditionally, it has been difficult for individual investors to access bonds because of the high minimum investment required (often up to $500,000).

However, some bonds are targeted at individual investors and have lower minimum investments required. Additionally, bond funds allow individual investors to access the asset class. However, there has been a lot of discussion in the financial press about what the future holds for bond investments. As far back as 2013 bond market stalwarts such as Bill Gross, founder of PIMCO, were calling the end of the bond bull market and the Bank of England’s director of financial stability, Andy Haldane, (now Chief Economist and Executive Director, Monetary Analysis & Statistics) was arguing that we were experiencing the biggest bond bubble in history.

It is fair to say that anyone who claims to be able to predict exactly how the bond bubble will end is either a genius or deluded. Certainly, a range of powerful national governments and central banks will be trying hard to control it. However, risks abound and investors should invest in bonds with their eyes wide open to these.

Hybrid notes

A popular alternative to bond investments in some circles is hybrid notes. These are difficult to assess as a class, because their merits are so dependent on the detail of each individual hybrid issue. The ideal hybrid seeks to deliver higher returns (like shares) with lower risk (like bonds/fixed interest investments).

Unfortunately for investors, the opposite is all too often true. Investors are exposed to fixed interest returns, in compensation for running risks more commonly associated with shares.

The difficulty most investors face with hybrids is separating the ‘wheat from the chaff’. The standard hybrid offer document typically runs into hundreds of pages and is full of highly technical terms and conditions. Frequently and particularly with bank hybrids a detailed understanding of legal and regulatory issues like banking capital requirements and APRA’s regulation of these is required.

The complexity of individual hybrids might make the investment decision simply too onerous for individual investors. As Warren Buffett once said “investing is not like Olympic diving – you don’t get bonus points for degree of difficulty.”

Equities

The final income strategy that we will consider is investing in shares, or equities. Since 2011, many investors have been investing in equities for the dividend yield. There is little doubt that this strategy has been successful over this period. There have been some very strong dividend yields on offer, often boosted significantly by franking credits.

However, it is important that investors do not forget the fundamental characteristics of equity investment. As we all know, fixed interest investments typically do not deliver returns as high as equity investments, but, in exchange, investors get greater certainty of return.

Equity investments expose investors to capital risk. The S&P/ASX 200 dropped nearly 50% during the GFC and nine years later is still down by about 15% on its pre-GFC high. For SMSF investors who need to sell down portfolios for living expenses, this is a very significant capital hit.

Importantly, whilst fixed interest yields derive from legal obligations (the ‘borrower’ has a legal obligation to make repayments), a dividend is by its very nature discretionary. It might look solid right now, but if circumstances for the company in question change, the dividend is the first thing to be dropped.

Underlying capital and income risks is the fundamental equity risk of volatility. Equity markets and individual equities are prone to volatility and as we’ve already seen this volatility can result in multi-year or even decade-long periods of underperformance.

A current darling of the ‘equities for income’ strategy is Telstra and understandably so. But an objective, long-term observation of the Telstra share price reveals a very mixed picture for its investors.

Again, this is not to deny the validity of equity-based yield investment strategies. It is simply to say that investors should ensure that the real risks of this strategy are taken into account.

Conclusion

Investing for income is here to stay and it is always appropriate for investors to consider which strategies suit their individual needs and objectives. However, no strategy is foolproof and each has its own profile of benefits and risks. Investors need to assess these in detail to ensure that their strategy matches their individual risk profile.

What’s more, there are yield-generating alternatives beyond these ‘usual suspects’. At La Trobe Financial, we target the generation of income through mortgage-backed investment. Our ‘peer to peer’ investment options allow investors to choose individual loans from our Investment Shopping list that suit their own needs and objectives.

Click here to view La Trobe Financial’s Investment Shopping List

Our 12 Month Term Account offers a truly national, diversified portfolio of income-generating loans.

Since inception in 2002, it has produced a powerful income return for its investors. Its capital stability (zero investor capital losses) and liquidity profile (full capital return on investment maturity) has been coupled with monthly income returns that have been strong both in absolute terms and relative to peers.


Money magazine’s Best
of the Best 2017

Our 12 Month Term Account has won Gold in Money magazine’s Best of the Best 2017 Awards. Our eighth consecutive win. A strong track record reassures investors who want a regular income.


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La Trobe Financial Services Pty Limited ACN 006 479 527 Australian Credit Licence 392385
La Trobe Financial Asset Management Limited ACN 007 332 363 Australian Financial Services Licence 222213 Australian Credit Licence 222213 is the issuer and manager of the La Trobe Australian Credit Fund ARSN 088 178 321. It is important for you to consider the Product Disclosure Statement for the Credit Fund in deciding whether to invest, or to continue to invest, in the Credit Fund. You can read the PDS on our website latrobefinancial.com or ask for a copy by telephoning us on 1800 818 818. *Returns on our investments are variable and paid monthly. Past performance is not a reliable indicator of future performance. The rates of return from the Credit Fund are not guaranteed and are determined by the future revenue of the Credit Fund and may be lower than expected. Investors risk losing some or all of their principal investment. An investment in the Credit Fund is not a bank deposit. Withdrawal rights are subject to liquidity and may be delayed or suspended. Visit our website for further information.

Copyright 2017 La Trobe Financial Services Pty Limited ACN 006 479 527. All rights reserved. No portion of this may be reproduced, copied, or in any way reused without written permission from La Trobe Financial.

This publication does not constitute financial advice and should not be relied upon as such. It is intended only to provide a summary and a general overview on matters of interest and it is not intended to be comprehensive. You should seek your own financial or other professional advice before acting or relying on any of the content.