“It is reasonable to expect that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieve more assured progress towards the inflation target.”
Reserve Bank Governor, Phillip Lowe, Monetary Policy Decision, 6 August 2019.
There are two groups of Australians who follow the RBA’s interest rate announcements with as much fervour as any economist. Mortgage-burdened Australians want rates to fall. Cashed-up savers – especially retirees – want rates to rise.
Hitting new Lowes
Right now, the mortgagees are winning – and they have been for a while. In August 2008 the RBA Target Cash Rate was 7.25%. In August 2019 it is 1%.1 Post GFC, low inflation, rate cuts and quantitative easing in the US and Europe have put downward pressure on returns from cash and cash-type investment products. With the global economy slowing and the Australia economy following the pack, it looks like savers are in for another sustained bout of income reduction. The quote from RBA Governor Lowe above almost guarantees it.
So, what can savers and retirees do to maintain their lifestyle? And just as importantly, ensure the chase for yield doesn’t increase their short-term cashflow at the cost of their long-term security?
The downside of the risk curve
In a world where cash rates are tumbling, the obvious investment alternative are assets where yields are higher. That can mean moving towards hybrids, property trusts, residential property and high-yield shares. All of these assets can have a place in your portfolio. The issue is that changing your asset allocation to chase yield can put your capital at more risk.
As Kyle Lidbury, Head of Investments Research, explains in the video, a by-product of the chase for yield is a loss of diversification – you’re moving more of your capital away from the assets designed to protect you in a market crash. So you could be exchanging income for insecurity.
So, what are the alternatives?
How do investors replace income lost to the ravages of falling rates? According to both Richard McClelland and Kyle Lidbury, there are three strategic alternatives.
- See the whole board
A well-diversified portfolio will contain assets that generate different kinds of income at different times. Cash income is more predictable, but less tax-effective. Share income is more variable – but that income is more likely to increase over time if the underlying companies are growing their profits. Professional investors think about the total return a portfolio can generate and how to use all the income it generates.
That approach frees you to draw down on capital at times when income is weak – and rebuild that capital base by reinvesting income at times when the portfolio is providing higher than required income.
That strategy puts the variability in investment returns to use for you and not against you. It’s investors who have been too income conscious and overinvested in cash and term deposits that are most affected by the cash crash of recent years.
- Invest more widely
One of the big opportunities to generate greater returns – and greater income - from your portfolio comes from the breadth of your diversification. The traditional split between cash, bonds, property and shares is better than being overinvested in one asset class. Adding an international angle is even better. After all, Australian shares make up less than 2% of the world market – and Australian bonds an even more paltry 1%.2 If you want real diversification your money has to travel to find it.
The sophistication of modern financial markets offers income-seeking investors even more options. Infrastructure investing and private equity funds are increasingly used by high net worth investors. For even broader diversification, funds like the Perpetual Income Opportunities Fund invest in areas like “private credit”. Private credit companies or funds are taking over some of the banks’ traditional role of providing capital to quality businesses and real estate companies. To get the most out of this asset class, Perpetual seeks lending opportunities that are secured against real assets.
- Invest in alternatives
One of the weaknesses of traditional diversification, especially into shares and property, is that while they do have different investment characteristics in what we might call normal market conditions, in times of crisis these two growth asset classes tend to fall together, thus reducing the risk-management benefits of diversification.
By contrast, alternative assets – including absolute return strategies – are driven less by the performance of the underlying asset classes and more by investment manager skill. There are funds that buy and sell assets based on particular economic themes, others that specialise in futures and options trading. Some invest in distressed debt – buying into higher-risk, higher returning debt securities where and when they believe those securities can perform better than expected and generate an outsized return.
For many investors, these strategies can offer wider diversification of risk and the chance to generate income returns in market conditions that traditionally have been difficult ones for income investors – like now.
Discipline and disciplines
The essence of all these income strategies is twofold:
- It’s not always appropriate to “double down” in so-called income assets like cash and term deposits. A focus on broader diversification and total return may give you more income flexibility over the short and longer-term.
- The chase for yield by simply investing in riskier assets – like high yielding shares - can be a dangerous one. Broader diversification and the discipline to stick to a long-term strategy that aligns with your income needs and your risk profile is crucial.
Advice from a professional – one with access to a wider range of assets, a longer-term view and a dispassionate read on your situation - can be crucial.
Contact Perpetual now if you’d like to speak to an adviser about sophisticated strategies that can help you earn the money you need to live on now and in the future.
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