With volatile markets and growth set to slow, professional investors outline how to target inflation-beating income without taking on too much risk.

Investors can target returns of about six per cent, or more than three times the rate of inflation, without exposing nest eggs to excessive risks from increasingly volatile equity and fixed income markets.

Investment specialists are generating the returns by combining a diversified mix of Australian shares that have a long track record of stable and sustainable dividends with managed fund exposure to unlisted commercial property and infrastructure investments.

Many investors, particularly those four million retired Australians managing their retirement finances, have long struggled with record-low cash rates. Now they're further challenged by the deterioration in the global growth outlook, signalled by plunging bond yields.

Finding decent yield with with minimal downside is not easy
Finding decent yield with with minimal downside is not easy. Simon Letch

Toya Adams, a retiree who runs her self managed super fund, says: “As an active self-directed investor, I have my head on the chopping block for I am ultimately responsible.”

She adds: “I am on high alert for, as signalled by the bond market’s yield curve inversion, the end of this long bull market may be nigh, and I am concerned about the depth of the next bear market."

Investors are also calculating the impact on their investment portfolios and retirement income of planned changes to franking credits.

Self-funded retirees could be worse off by more than 17 per cent compared with other retirees on the part pension under Labor's proposal to end cash rebates for excess franking credits, according to independent modelling. Other estimates of possible impact are even higher.

Headline inflation is below 2 per cent but the cost of living for retirees and those on fixed incomes has been rising much faster, with healthcare costs increasing more than 4 per cent and energy up 20 per cent in some states. “Generating a return that beats inflation is one thing,” says Adams. "Many retirees must generate more income to meet the higher inflation rate of the basket of goods they are needing as they age."

Toya Adams
Toya Adams is reviewing her
investment portfolio. afr

Shane Oliver, head of investment strategy and chief economist for AMP Capital, which manages about $190 billion, says generating returns of about 6 per cent with little downside risk is “not easy” in current markets.

Investors seeking higher returns also need to weigh up the extra effort and costs of exposing their capital to risk, choosing between competing asset managers and paying fees, which vary widely.

Recent star performers, such as residential real estate and some retail shopping property assets, are falling in value as demand for the underlying assets fall and costs rise.

But funds specialising in commercial and industrial property and infrastructure that diversify risk are still offering strong returns.

“Comparing the performance of commercial with residential property is like comparing Aussie rules with rugby,” says Steve Bennett, who oversees the management of more than $4 billion in property assets with Charter Hall, an ASX-listed property manager.

Its Direct Industrial Fund, which invests in well-located, long-leased Australian industrial properties, is yielding 6 per cent. The fund’s property assets have 100 per cent occupancy, an average lease of 11 years and quarterly distributions. Its 10-year average returns has been about 10 per cent a year.

Australian Unity has a property income fund offering similar returns investing across a range of commercial property assets, unlisted and listed property trusts suitable for conservative investors.

Property funds also offer some wealth management advantages because a portion of the income return is not taxed in the year the cash flow is received which means tax can be deferred, say, until after retirement. It also enables deferring payment of capital gains tax until after retirement.

But Paul Moran, principal financial planner with Moran & Partners, an accredited financial adviser, has a word of caution. "Any investment that moves away from capital guarantees, such as term deposits, should be monitored at least quarterly to ensure no significant changes to either the economic environment or management team," he says.

Property manager Freehold Investment Management has generated net income of 6.5 per cent a year for the past three years, targeting listed infrastructure securities and listed property trusts.

Grant McKenzie, portfolio manager, says: “Vacancies are at record lows and new supply is still two years away. Industrial property is benefiting from an e-commerce boom.”

Investors considering unlisted property assets need to look for well-diversified portfolios, long leases, structure their holdings around their liquidity needs, check when and how the underlying assets are valued and be comfortable with gearing. A gearing – or borrowing – ratio of between 30 and 35 per cent is considered reasonable.

“Aiming for a return of six per cent to 8 per cent by definition requires taking on risk in terms of the volatility of the investor’s underlying capital base,” says Oliver.

“One way to do it would be to invest in a diversified mix of Australian shares that have a long-term track record of paying decent, stable and sustainable dividends,” he says.

Most major fund managers offer dividend reaper funds.

For example, Vanguard's High Yield Australian Shares Fund includes the nation’s top dividend-paying blue-chip listed companies. Returns have increased from about 5 per cent last year to about 10 per cent so far this year. Annual fees are 25 basis points.

Cash and fixed interest

Future markets are pricing in at least one interest rate cut – and possibly two – by the end of the year from the record-low long-term cash rate of 1.5 per cent.

Returns on savings accounts continue to fall across all fixed term and variable categories, a review of rates by Canstar, which monitors returns and costs, reveals.

For example, base rates on variable savings accounts have slipped an average of 40 basis points in recent weeks. The average return is 1.3 per cent with rates ranging from 10 basis points to a maximum of 2.2 per cent.

Rates on fixed terms from one month to five years have fallen by around 15 basis points with a top-paying five year term deposit yielding about 3.2 per cent.

A risk-free alternative is being offered by HSBC Australia, which is targeting investors aiming to escape volatile markets with a 2.5 per cent interest for minimum balance of $5 million.

Perpetual is launching a credit income trust offering exposure to between 50 and 100 fixed income assets diversified by asset type, credit quality, loan maturity, country and issuer. It is targeting a return of the Reserve Bank of Australia cash rate – which is 1.5 per cent – plus 3.25 per cent, net of fees. The subscription price is $1.10 per unit and the minimum application is $2200. It will provide monthly cash distributions.

Shane Oliver
Aiming for a return of 6-8 per cent by
definition requires taking on risk, says
Shane Oliver. Photographic

Adrian Frinsdorf, a director of wealth advisory at William Buck, says fixed interest through corporate and government bonds is a “forgotten asset class”.

“There is a very large bond market available domestically and globally that has a range of different providers and different rates. [But] these investments are generally only available to institutional and high net worth investors with a minimum of $500,000.

“Yields for credit-rated bonds range from 2 to 4.5 per cent depending on the time frame,” Frinsdorf says.

“Many bonds are from major global banks and while they do not carry the government guarantee and are slightly lower in the credit profile, if you believe the bank will stay solvent then you will be rewarded with an extra two per cent.”

Alternatively, there are investments that pay a fixed rate above a variable margin, which are called floating notes.

For example, IAG issued a five-year bond paying 2.35 per cent above the 90-day bank bill rate, which is 1.81 per cent.

Leading global fund managers, including Vanguard, BT and Pimco, have a range of funds targeting these sectors with a yield around 4 per cent.

Cameron Harrison, a local fund manager advised by former Morgan Stanley global strategist Gerard Minack, says a managed portfolio of US corporate bonds is expected to yield between 6 and 6.5 per cent.

Minack, who called the 2008 financial crisis, is highly regarded for investment strategies based on his reading of global trends.

David Clark, Cameron Harrison director of investment management, says: “As domestic yields have been flat or heading south, the US Federal Reserve has been driving up rates to slow down their roaring economy. This is providing attractive opportunities for corporate credit.”

Harrison recommends Neuberger Berman Global Income NB global corporate income trust.

Higher yield, higher risk

There are many opportunities for investors chasing double-digit returns but they come at a price.

For example, specialist non-bank lenders are offering returns of more than 10 per cent investing in residential mortgage backed securities.

“But if the underlying asset falls you are in strife,” warns Moran. “There is the potential for 100 per cent loss.”

Source: Originally published by Duncan Hughes in the Australian Financial Review on March 30, 2019.

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