Singing from the lower-for-longer hymn sheet

  • 15.Jul.2016
  • Hope William-Smith,  Money Management

There has never been a more fitting time for planners and investors to reconsider their asset allocations to bring in the dollars.

As we breach the dawn of a new financial year, it is apparent that central banks and markets are expecting the current low interest rates to prevail.

In May, the Reserve Bank of Australia (RBA) reduced the cash rate to a record low of 1.75 per cent.

The current financial environment is largely unprecedented and, according to the Australian Corporate Bond Company (ACBC) chief executive, Richard Murphy, “everyone is singing from the lower-for-longer hymn sheet” as they try to work against potential repercussions of volatility.

For planners, dealing with an uncertain period is not without problems.

According to an analysis by BT Investment head of income and fixed interest, Vimal Gor, interest rates would continue to drop, and planners needed to decipher what the cash rate meant for the asset classes.

“We have been positioned for this cut for a while now and generated strong returns when it happened. In the RBA SOMP [statement of monetary policy] following the cut, the RBA market-to-market view…stated the next rate cutting cycle will take rates to one per cent if not lower,” he said.

According to Bentham Asset Management’s managing director, Richard Quin, global activity is generally healthy and the Australian economy had done better than expected in last year’s forecasting, but investors were still unsure.

The 2016 Vanguard Economic and Investment Outlook found fixed income returns bore relatively low correlations to returns from typically riskier asset classes. The outlook for bonds remained guarded in the low interest rate environment, with the world in a secular, rather than cyclical phase, where the return for fixed income assets remained positive, yet muted.

Property, which carried a higher investment risk than fixed interest and was classified as a short-term asset, had garnered little attention recently, as planners tried to navigate the balance between risk and return.

The analysis also noted that risks remained tilted to the downside as the economy navigated the transition from mining-led to broad-based growth. Advisers were now looking for ways to help clients maximise income, while acknowledging longevity risk and capital protection.

PIMCO’s managing director and head of portfolio management in Australia, Robert Mead, said advisers needed to realistically assess what sort of volatility each investor could handle.

Think medium term

Ord Minnett fixed interest analyst, Brad Dunn, said: “If you get your strategies right in the first place, anyone can ride out volatility”.

He stated there were allocations towards sectors that paid better yields than currently available in cash during a time where investors, uncertain and misinformed, switched between equities into fixed income.

The most significant risk in making decisions in an uncertain environment was planners advising clients into products neither party understood, Mead said.

Quin said that while rash decisions could sometimes be reversed, only thinking of yield was a dangerous down path where high-cost risks were often not properly considered.

“Making lots of decisions now is not a great idea. You have to think medium-term about investment and if you are thinking short-term, you could make a lot of mistakes,” Quin said.

“We are in a very low rate environment and term risk premiums are negative right now, which we have not seen in a lifetimeā€¦ the mistake is buying things that are expensive.”

Phoenix Portfolios managing director, Stuart Cartledge, agreed that short-term planning placed investors at high risk.

“One day cash will go back up again and the weight of money that has been pushing pricing will become a headwind, rather than a tailwind. What they might gain on short-term income yield might eventually be offset,” Cartledge said.

Cartledge asserted that planners should point to the benefits of a structured plan to see out the volatile period, so if interest rates rose there was a chance for headwinds in all markets.

Mead said that investors needed to face facts and make realistic decisions for effective management.

“Volatility is here to stay and the level of interest rates is clearly suggesting that growth rates of economies are also going to be low,” Mead said.

“Expected returns from every asset class will also be lowerā€¦ investors should be much more pragmatic around identifying how much risk is appropriate.”

According to Merlon principal and lead portfolio manager, Neil Margolis, the focus should be on dividends rather than yield.

“The Australian share market has a deep opportunity set for active income investing,” Margolis said.

“There is no shortage of value opportunitiesā€¦we are entering a period of the investment cycle where bottom-up revenue and sustainable cashflow forecasting, valuation and risk analysis work will pay off.

“Much of the current market volatility is caused by events that fundamentally don’t really matter to the long-term value of most Australian companies.”

Finding the right strategy

Mead noted that investing was not all about the return.

“Investing is trying to maximise risk adjusted returns to the extent that you have assets in the portfolio that are not correlated with other assets,” he said.

“Then the riskiness of the portfolio goes down.”

In a period where stability is insecure, Mead suggested that advisers needed to remember that things could change quickly.

“Some of the preferred sources of portfolio income over the past two years actually have a huge amount of market-to-market volatility associated with them,” he said.

“It is very important to consider not only what the headline yield is, but much more importantly, what sort of capital price volatility that implies.”

Mead said that a low cash rate was a clear sign that inflation, growth rates, earnings growth, and economic growth would be low.

“There is a time at the moment to diversify completely across all asset classes,” he said.

“If an adviser is running a very aggressive, risk-on portfolio, they should be de-riskingā€¦given that political risk is elevated, given that we know the rebalancing of the Australian economy is quite vulnerable. Some of the political decisions that have played out around the world are not supportive of an improvement in the economic outlook.

“Ensuring that there are enough assets in there that are true diversifiersā€¦should be the starting point of any efficient portfolio.”

When planners look to strategise for retiree clients, Margolis recommended investing in income through a diversified portfolio of listed shares based on the cash flows of underlying companies. This should be combined with an element of downside protection for the future.

“A key advantage of deriving income from listed shares is franking credits, which alone amount to almost two per cent per annum cash yield for retirees. When combined with dividends, the cash yield for retirees can be five per cent above term deposits,” Margolis said.

“Other advantages over traditional fixed interest include growth in the income stream to offset inflation, and the ability to redeem the investment without notice or penalty should investor circumstances change.”

Margolis said that planners must note that income should be sourced reflecting an over-reliance on the largest companies in the Australian shares index, such as banks or miners. This should be overlayed with downside protection to preserve the full tax-effective income, while reducing the risk of capital loss should all share prices fall due to macro events.

According to Vanguard, high quality fixed income securities, such as government bonds, were a safe-haven in volatile markets, as were Australian real estate investment trusts (A-REITs), which may appeal to investors looking to diversify their portfolio into property and receive a consistent income stream.

“[A-REITs] are getting more attention because of the hunt for yield. Within the broader equity market, with more downgrades to earnings than upgrades, the property sectors looks more robust,” Cartledge said.

Quin also recommended looking at the floating rate debt as it paid a coupon above the margin.

“The problem with interest rate risk now is that it has got a lot longer in the market because a lot of people have borrowed more at rates that are beneficial to them, but at a very low rate for investors who are on a fixed rate basis,” he said.

“You want to have a coupon that is senior and secured. Whether that’s asset-backed or against the company, it is important you have security to protect against the dollars.”

Quin suggested strategising away from long interest rate risk and long bonds as they were ineffective and yielded very little, and benefited from investing in a deposit.

“You are not getting a real return after investment and you are taking the risk that interest rates could go back up,” Quin said.

“Relative to history in Australiaā€¦ you get paid above the expected inflation rate and now we are not getting paid, we are getting negative.”

The ‘How To’ of diversification

The consensus across the industry is a need for diversification across different asset classes, and according to BondAdviser head of research, Nick Yaxley, planners needed to specialise their understanding toward one sector.

Yaxley said while bonds of different maturities and a mix of stocks across different sectors suggested a well-diversified portfolio, the idea of in-sector diversification was becoming popular. This could either reduce risk or improve a portfolio’s overall rate of return, meaning investors may feel more comfortable taking on greater risk.

According to Mead, a strong portfolio should include bonds, as they generated income, but with a higher degree of capital stability than more risky assets.

While Quin’s strategy was to invest and diversify offshore, he warned that planners who were unsure of the benefits of investing in international markets may not be well versed in it, and could be providing inappropriate advice.

“There needs to be the acknowledgement that risks are correlated and tend to move in a pack, so ensuring there are enough assets in there that are true diversifiers should be the starting point of any official portfolio,” Quin said.

Quin recommended that planners buy assets to increase portfolio diversification in areas they were comfortable advising on.

According to Mead, when guided properly, there was also still a place for equities in portfolios with stable dividend streams, especially in equity streams which had been re-priced lower.

“There should be some allocation towards dividend stocks and some allocation towards hybrid-type instruments,” he said.

Mead noted that bonds and multi-asset investments would also continue to attract more attention in the current environment, with a shift towards an older median age of investors whose primary income generation focus was to create a stable retirement fund.

“As our investor base ages and as retirement income becomes more importantā€¦if someone is older, their ability to under ride volatility is lower. Bonds are a much more compelling addition to your portfolio,” Mead said.

“When we look back 12 months, bonds generated between six and eight per cent returns and reduced portfolio risk and added return.”

Mead said the inclusion of fixed income in a portfolio alongside other asset classes remained the strongest approach, as the benefits of diversification to slowly correlated asset classes provided a lower than average volatility in portfolio return outcomes.

Investment-grade fixed income in a balanced portfolio would also likely persist under the majority of risk holes associated with volatility in the low interest market ā€” a consideration Vanguard said planners should not discount.

Avoiding pitfalls

Vanguard noted that the negative correlation usually observed between equities and fixed incomes could now provide less volatile returns than the weighted average risk of each asset class separately ā€” a pitfall that could confuse investors and trap advisers.

Margolis said the most common mistake was focusing on headline dividend yield, which often reflected out-dated conditions.

“Financial markets price assets based on forward expectations. The upside for investors in many asset classes is becoming increasingly capped in a low growth world, meaning that the downside risk continues to increase,” he said.

“The core mistake that many investors make is continuing to pay higher prices for the same dividend streams from the same large cap companies and big banks.”

He also identified a common failing to appreciate that companies were able to artificially boost their yield, effectively putting a short-term price at the expense of their long-term sustainability. While obviously risky, this has worked well in past periods of volatility.

Moving forwards to 2017, Mead said monetary policy was the key deciding factor of the future.

“The RBA, in our view, will have no choice but to continue to provide additional monetary accommodation, [for the current situation] which puts interest rates falling over the next two years by another 50 to 75 basis points.”

Companies would increasingly need to be able to meet expectations of their cash hungry and desperate investors, while planners adjusted their methods to suit the new and prevailing unstable norm.

Source: Money Management


  • 07Dec 2021

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