I remember when I first started in the investment industry in 1998. A conservative self-funded retiree investing $2,000,000 in term deposits at 5% was easily able to secure a retirement income of $100,000 pa. It also doesn’t seem that long ago that I was able to lock in 7.00% pa fixed for 12 months on a term deposit for clients. That was 2007 just as the GFC hit and changed the investment landscape forever. Today, the best you can get for a term deposit is around 0.30% and that same $2,000,000 generates income of only $6,000 pa for the risk adverse investor. It is an incredible difference, a massive pay cut and reduction in the standard of living for people in that bracket.
What it means in reality is that the most conservative investors have to choose to either dip into capital or increase the level of risk they take to access higher yielding investments. For more sophisticated investors and larger portfolios this is still a problem. The allocation of funds to growth investments such as stocks and property tend to dominate investor attention. However, depending on the investor, traditionally a portfolio would have an allocation of somewhere between 10-50% to defensive assets too. These assets, such as cash, term deposits, domestic and international bonds, corporate bonds and hybrid note securities are intended to diversify risk, provide income and stability of capital.
In today’s low yield environment how suitable are these options really? Cash and term deposits earn next to nothing. The yield on international bonds is so low that in some cases it’s actually negative. The biggest problem for bonds is if interest rates go up. It’s going to be a massive problem for bond investors. The value of bonds is more volatile than many investors appreciate. If the government bonds you hold are paying 1% on a $100 bond, then it’s going to be worth a lot less next year if the yield on new bonds issued is 2% on $100 bond. The higher interest rates rise the greater bond values will fall.
Bank hybrid note securities are interesting. They are considered at the riskier end of the defensive style assets and sit somewhere between shares and a bond, but they remain relatively attractive for a couple of reasons. The yield is a reasonable 2.5% to 4.0% but most importantly many have a floating interest rate. In other words, if interest rates go up, so too does the yield on the hybrid notes. This provides investors with higher income and will help them retain their capital value too.
My point here is that in the past, government bonds would provide yield and capital stability. But because of the unusual times we live in I don’t believe bonds provide either very well anymore. Increasingly, investors are allocating a greater proportion of their portfolio towards growth assets and reducing their exposure to defensive assets. It’s hard to disagree. While I favour holding cash to take advantage of potential buying opportunities, for most defensive assets there is a lot of potential downside risk and not a lot of potential upside gain. If we do enter a phase of rising inflation, investments that provide a hedge against subsequent rising interest rates are preferrable to those that don’t. To that end, it may be worth considering the potential benefits of floating rate investments and inflation linked bonds going forward as part of the allocation to defensive assets.
This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.