Sun Herald: Investing for Income

AFR Investor, Sun Herald and Sunday Age

There’s nothing like a stock market collapse to remind people how useful bonds can be. Investors with a decent allocation to defensive investments such as bond funds enjoyed a buffer from the financial crisis, and while it may have seemed a drag during the market rebound of the last nine months, that’s more than compensated for by the insulation it provided on the way down.

Terms like ‘income’ or ‘defensive’ cover a multitude of different products, styles and ideas. They go from tedious plodding cash and bond funds through mortgage funds to high-risk, high-reward credit products and even into high yielding stocks. The boxes on this page talk about the different types of products available and how to tell them apart.

As a rule of thumb, though, this type of investment has become a lot simpler since the global financial crisis, as the things that looked clever and lucrative a few years ago were often the ones that came unstuck. “The last two years have seen an incredible turnaround in the types of investment people have been considering for the income component of their portfolio,” says Peter Dorrian, head of Australian retail at Pimco, one of the world’s leading fixed income managers.

“If you think back to 2006, bond funds struggled to gain a lot of traction because the income investment class was dominated by things like mortgage funds, highly geared property funds, and even hedge fund of funds.” But all those areas ran into trouble for one reason or another and the trend today is towards the straightforward. “The little old bond market, long forgotten by investors, has suddenly got increased interest.”

Adam Coughlan, general manager for retail at Australian Unity Investments, agrees. “Where investors got themselves into trouble in the financial crisis was with some of the very high yielding types of products available,” he says. “I would say this: if it seems too good to be true, it is. Now we’re starting to see people using bond funds more for their traditional defensive purposes.”

Data from fund researcher Morningstar shows that of the 116 new income funds launched in 2009, 82 were at the straightforward end of things: Australian cash, Aussie bonds, global bonds or a combination of the two. Just three mortgage funds appeared.

So what should investors think about when looking for income products? “There are two related but different roles a defensive asset can play in your portfolio,” says Dorrian. “Firstly as a buffer against the volatility of the equity markets and global asset markets, and secondly as a provider of income to a portfolio on a very dependable and reliable basis.”

“When you go into any bond fund there are two risks you need to think about,” he adds. “One is the risk of not getting income, the other is the risk of not getting 100 cents in the dollar back when it matures.” That risk varies depending on who issued the bond. A government, for example, can raise taxes to ensure it repays its debts; a company can’t do that and has to rely on its own balance sheet. 

So just as with stocks, an important decision to make is just what level of risk you want to take. Government bonds won’t generate much money but they’re unlikely to fall over. Corporate bonds pay out more, for more risk. Globally, professional investors have spent much of the last year trying to work out how best to take advantage of opportunities in what is called credit: higher yielding, riskier bonds from companies. “One trend I’ve noticed in the last 12 months is an interest in credit funds, born out of an incredible spike in the yields and returns available,” says Dorrian; two Pimco funds sold in Australia have some credit exposure and he says “both have had good inflows from investors in the last 12 months.”

But in an area like this it is essential to have professional management involved. It can be difficult for investors to access, and tricky to understand. “We think it is very important for people to understand the systemic risk in any part of the market they invest in,” says Kathy Cave a portfolio manager at Russell Investments. “When you buy equity there is a list of shares – the ASX 300, for example – but in fixed income that’s not the case.”

Another decision to make is whether you want international exposure. “When you’re buying an offshore bond, you are taking on a whole different level and style of risk,” says Coughlan. “The first one investors need to be conscious of is the exchange rate: the Australian dollar is at historically high levels but if it continues to go up then income will naturally go down in Australian dollar terms. That’s probably the biggest risk those investors will face.”

The risk Coughlan refers to – that gains on your overseas investments will be wiped out by a rising Aussie dollar – can be mitigated: many products offer a hedged and an unhedged version, giving you a choice about whether you want to be exposed to movements in currencies.

A separate point, though, is where the best prospects are. Australia is a high-interest country: the Reserve Bank of Australia has for many years set interest rates higher than is common in other major economies like the US or Japan, and the gap is getting wider now as the bank raises rates while other countries are still keeping them low as they emerge from the financial crisis.

“We’re a big believer in diversifying your portfolio so you need to have exposure outside Australia,” says Dorrian. “But the other side of the argument is that Australia has traditionally been a higher interest rate country than many around the world: the US cash rate is virtually zero and it doesn’t look like changing until early 2011. Australia has come through in better shape and investment returns from the bond markets look pretty promising in the next 12 to 18 months.”

Not everyone agrees where the opportunities are. “We actually think international might be more attractive than domestic bonds at this point,” says Cave at Russell, which recently changed the strategic asset allocation in its multimanager products to increase the allocation towards international bonds. Greg Michel says ING Investment Management, where he is director of fixed income, has a bias for interest rate exposure in Australia versus the UK, US and Japan. In any case, as he points out: “The fixed income market is already a global market when you consider the range of issuers in Australian dollars – a multitude of foreign financial institutions and supranationals whose businesses are operated in the main well outside Australia. At the same time, most of the larger iconic Australian companies are active borrowers in foreign capital markets.”

A third question is when it is time to return to unloved assets – and in particular, mortgage funds. Many of these ran into serious liquidity problems during the global financial crisis and investors have not been quick to forgive them, but Coughlan at Australian Unity argues that many were perhaps misusing them in the first place.

“The typical mortgage fund was used by two types of investor,” he says. “The first type was using it as, in effect, a high returning bank account. The other type was a pension style client who saw a rate of interest better than the banks.

“When the financial crisis hit, the first group were the ones that didn’t want to be trapped in there – they were really using them not in the way they had been designed.” Their attempts to exit swiftly led to problems such as redemption freezes. But, Coughlan says, “the lesson has been learned, removing these investors from the funds and leaving in place the pension style client who the product is best suited for. Most mortgage fund providers by the end of this quarter will be through that process and we’ll see a really good level of stability from those funds. Things are definitely looking up for the mortgage fund sector in 2010.”

All providers agree that the push towards income products is driven by a broader change in Australian society. “We are seeing a demographic shift,” says Craig Hobart, head of retail at Tyndall Investment Management. “More baby boomers are approaching retirement, and demand for quality income streams is something we have identified as a gap.” And Cave at Russell speaks of “a focus on people who are in the post-accumulation, decumulation phase of their lives,” says Russell. “They are no longer accumulating super but are starting to use it.”

Michel says people wanting a fund for income should consider the following key considerations in choosing a fund: the stability of the income stream; the creditworthiness of what that fund holds; any use of derivatives by the fund; entry and exit charges; the fund’s size; and the experience of the fund’s managers.

Australians today have a greater range of choice in this field than ever before, but for the moment, it seems they’re exercising that choice with greater caution than was the case before the financial crisis. And that’s no bad thing. “It would be very disappointing if we didn’t learn from our mistakes,” says Coughlan.

BOX: What’s an income fund?

You get a sense of the diversity of this style of investment by looking at fund research Morningstar’s classification of income products. The researcher considers them to fall in to 10 different camps, roughly along these lines:

• Australian cash: invest mainly in very liquid market securities like bank deposits and bank bills. They usually mature in less than 12 months.
• Australian cash enhanced: similar to Australian cash, but can also have exposure to bonds, corporate debt and asset-backed securities, and may use derivatives. Usually have about a 12 month duration.
• Mortgage funds: mainly invest in registered first mortgages secured over Australian property, but sometimes in fixed interest, money market securities or cash.
• Mortgage funds – aggressive: Like mortgage funds, but may invest 20% or more in mezzanine debt, development and construction loans, pre-developed land, or specialty loans such as to hotels and retirement villages.
• Australian bonds: invest in traditional Australian fixed interest securities such as government or Australian corporate bonds with a maturity of more than one year.
• Global bonds: invest in foreign government and corporate debt with a maturity of more than one year.
• Global/Australian bonds: Combine global and Australian bonds, with at least 25% of the total in Australian.
• Diversified credit funds: Invest in credit securities in Australia and/or worldwide. This involves active selection to try to get better returns than government bonds; usually they invest in securities rated BBB or above (the definition of investment grade), but not always.
• High yield: Invest in credit securities where the average credit quality is below BBB, or sub-investment grade (sometimes called junk). Typically invest heavily in emerging market debt, junk bonds, structured credit and unrated issues.
• Multi-strategy income: Combine different sectors to improve yield, which might include domestic and international government bonds, corporate debt, private debt and hybrid securities.

Even this impressive list does not include several other styles investors might consider as sources of income, such as high-yielding equity funds, or listed property funds.

Note: fixed income or fixed interest? Bankers and investors in most of the world use the term fixed income (even sometimes for bond products where the income isn’t actually fixed). In Australia, the term fixed interest tends to be used instead. They mean the same thing.

BOX: Income products and the financial crisis

Although income products are usually painted as defensive investments that protect you in the bad times, it’s worth recalling that it was bond-related products that kicked off sub-prime, which in turn led to the global financial crisis.

Five years ago, it had become common for investors to put money into products like collateralised debt obligations (CDOs), which packaged together dozens of debt instruments in order to make a return, usually combining leverage to boost that return. “But the leverage was not always appropriate and because you were investing in assets that were similar, it didn’t provide you with diversification benefits,” says Cave. “They could go badly wrong, and that’s what happened.”

Usually, if something goes wrong in an asset, it doesn’t affect the rest of the market. “The recent experience was dramatically different,” says Michel. “The freezing of markets for these assets was not a specific credit event but rather a market wide liquidity event, with many traditional income based assets being impacted.”As investors tried to pull out of funds that were never intended to face sudden redemptions from so many people simultaneously, the problem spiralled; it was in this environment that managers like Basis Capital had to suspend redemptions from funds and in some cases eventually shut them down at considerable cost to investors.

It wasn’t just CDOs. Peter Dorrian at Pimco recalls how investors had moved their income allocation out of safe bonds and into things like mortgage funds, property trusts and fund of hedge funds. In each case, something went wrong in these asset classes. “In the case of mortgage funds it was for structural reasons, where there was a mismatch between the ability to provide liquidity and the underlying assets they invested in,” he says. In hedge funds it was a similar problem: the liquidity of what the funds were invested in, versus the weight of redemptions seeking to get out. “And while most property trusts survived the crisis, they are engrossed in massive capital raisings which do nothing positive for investors other than reduce gearing levels.”

The financial crisis also gave guaranteed funds a bad name, for two reasons: in the worst cases, the bank that had provided the guarantee (such as Lehman Brothers) went under, rendering it useless; and in others, while investors didn’t lose their money, they found themselves locked into an unproductive fund for up to seven years.

While there’s still plenty of life in guaranteed products provided you trust the guarantor, there is still a sense of suspicion about them. “We have seen a few products launched that have some kind of guarantee attached to them,” says Cave. “It’s a different profile – some of them are fixed terms and are not necessarily simple investments. You are giving up the flexibility to get out of products for a guarantee over a period of time.”

Nevertheless Coughlan argues that “there are still good products out there that do what they’re meant to do but have a fixed rate of return.” Australian Unity offers a fixed term product – called an income note – secured on income from retirement villages. “Retirement income is very stable,” he says. “Something underpinned by real property is a safer way of getting income.” The notes are fixed at three, five and seven years, with interest ranging from 8 to 8.5% according to the term. “That’s a pretty attractive return for retirees.”

BOX: Yield stocks and income funds

While most investors think of bond funds when they talk about income product, the Australian share market supports a different kind of income product: the dividends on shares.

Australia has one of the world’s highest-yielding major stock markets. Better still, it’s the solid blue chips like Telstra and the Commonwealth Bank of Australia that tend to exhibit consistently high dividend yields.

High yielding stocks have a lot to recommend them. For a start, they provide the income from the dividend, which in many blue chip stocks is around 5 or 6% a year. Secondly, they may be fully-franked: this means the company has already paid the tax on them so you don’t have to pay tax on it yourself. And third, like any other share, you have a very good chance that the value of the share itself will go up over time.

Yields go up and down not only according to how much a company pays out, but how its share price is moving. If the share price goes up, that’s good because you get capital growth, but your yield expressed as a percentage will go down – because $1 a share when the share price is $30, is a lower percentage yield than $1 a share if the stock goes up to $60. Correspondingly, we have seen big movements in yields over the course of the last year as stocks have rebounded, from a peak of around 7.25% for the ASX 200 to about 3.7% today (or about 5.6% on a grossed-up basis taking into account the tax benefit).

While one can build a portfolio of yield stocks just by buying them through a broker, there are a number of funds that are designed to invest in shares from an income perspective. For example, Tyndall Investment Management launched one in late 2008 with a mandate to generate an income stream of 2% higher than the grossed up yield of the ASX 200 Accumulation Index (which, at the moment, means about 7.6%). It considers the capital growth of the stocks a secondary investment objective, and it tailors its investment technique to focus on after-tax returns.

“We’re trying to take a conservative approach to high yielding stocks: utilities, telcos, consumer staples and financials,” says Craig Hobart, head of retail at Tyndall. Big positions include Spark Infrastructure, Telstra, Westpac, Woolworths, Duet, Commonwealth Bank of Australia, AMP and Axa. Property trusts, notably, represent only a little exposure – through Lend Lease, which the index does not consider a property trust anyway.

So where does such a fund fit into a portfolio? “The traditional way of doing asset allocation is to have defensive and growth investments, with defensive being cash and fixed income, and growth being equities,” says Hobart. “With this product, rather than focusing the question around defensive and growth, it works when people say: what’s my income requirement?” Advisors talk to clients about what they need this year, next year and so on, and build a portfolio based on those income needs; a share income fund can be part of that approach.

There is some cause to hope for dividend payouts to increase in the year ahead. “One of the consequences of all the capital raising is that debt has really fallen and balance sheets in Australia are quite lazy now,” says Hobart. “Gearing ratios have fallen across the industry. The consequences of that are, as the economy recovers, corporates are going to be left with strong balance sheets.” That gives them options to do three things: share buybacks, which usually help the share price; increase dividends, which helps people who want income; or buy other businesses, which can be good or bad for a company. Hobart, naturally, is hoping they take the dividend option. “There was a time when companies did cut dividends – February 2009 was the worst we’ve seen in recent history in terms of dividend revision – but we’re through the eye of the storm and we’re going to see a far more normal dividend profile.”