Investors warned against chasing yield in low rates environment

In an uncertain investment environment, where capital growth is likely to slow after several boom years and rates seem to be structurally lower, investors are taking yield more seriously than ever. However, investors are warned that higher yield comes wit

This is according to Sean Segar, Head of Product at Nedgroup Investments Cash Solutions, who says investors are feeling the low interest rates more heavily in the current investment environment which is leading to an increased focus by income investors on where they place their funds. “Losing out on 1% when interest rates were 12% was not as big a deal as forfeiting 1% of yield with call at 5% - which effectively means giving up 20% of the potential return,” he says.

The problem, according to Segar, is that many investors overlook the relationship between yield and risk.

“Higher yield comes with higher risk. The financial markets ensure that yields are a very good indicator of risk. Furthermore, the many professional money managers and treasurers operating in financial markets make these markets efficient. It is therefore highly unlikely that individual investors or their financial advisors will come across an investment that offers a superior yield at a low risk – because, if such an opportunity did exist it would very quickly be priced to market by the professionals,” he warns.

Investors should focus rather on avoiding losers than trying to pick winners. “In cricketing terms – go for the singles!” he says.

He provides the following rules for investors to follow to ensure that even in a low yield environment funds are optimally invested and that some of the potential traps are avoided:

Rules for income investing

Rule #1 Use the risk-free rate as the base reference point

The risk-free rate is normally the yield on government paper for the comparable period. Once you have established what the risk-free rate is, it is easier to assess if additional yield is worth the additional risk. Should a risk appears above where it should be relative to the risk return spectrum do not invest.

Rule #2 Understand what you are investing in

When investing in an interest paying instrument or unit trust portfolio ensure you take the following steps:

· Understand if the rate quoted is effective or nominal, and if it is net or gross of fees.

· Ensure costs are reasonable. Income type funds are typically cheaper than equity and balanced funds.

· Review the investment mandate to ensure that this does not permit investment in instruments you are not comfortable with. For example some income funds are permitted to invest in property, preference shares, offshore, non-investment grade credit, very long dated bonds, all of which offer generous yields but come with a higher risk of capital fluctuations.

· Avoid fads and look beyond the marketing message.

· Understand the regulatory environment of the product and the issuer.

Rule #3 Make use of pooled income funds

Pooled investment funds are convenient and offer the following advantages:

· Higher yields than call but access to funds is similar to call

· Spread of counterparty credit risk

· Ability to invest in longer dated instruments at higher yields but still having easy access to funds

· Unit trusts are regulated offering an additional level of comfort to investors

· Professional, specialist investment management

· Minimum investment amounts are relatively low unlike direct investments where the top interest rate is only earned by the largest of investors, or the interest rate is subject to a minimum balance

· Scale keeps fees low and provides the fund with buying power with banks and other issuers

Be comfortable with the investment mandate and the investment manager of any income fund ensuring they are reputable, credible, their investment philosophy is sound, they have a robust process, the team is suitably qualified and experienced with a good track record, and finally that the track record belongs to current team/individual manager.

Rule #4 Be sure that you have suitable access to your money

It is tempting to earn higher yields by fixing investments for a set term, however should you for some reason need to draw on such funds there are likely to be penalties. If you make fixed term investments ensure that you will not require the funds over the life of that term. Do not “lock up” your funds if you may need access to them.

Rule #5 Match income payment dates to your needs

Ensure that the frequency of the income distributions of the investment is in line with your needs. It will create unnecessary administration and even penalties should you have to tap into the investment’s capital to fund cash flow requirements. Some investments only distribute every six months or at the end of the investment term. On the other hand, should an investment distribute income more frequently than you require, reinvest this income rather than draw it unnecessarily. This will allow for compounding of returns and ensure you are not tempted to waste these funds. Always favour steady, predictable income streams.

Rule #6 Don’t leave cash on one-day call unless you might need it in one day

Ensure you are not sacrificing potential yield for the luxury of having immediate access to your funds, which in fact you do not need. The yield on daily call monies is lower than that on funds placed on term and cash should be put to work until it is required to be deployed.

Rule #7 Don’t be too conservative

There is such a thing as being too conservative. Most people can afford to take on an element of risk for which they should be rewarded through higher interest rates. Understand your level of risk tolerance and apply it.

Rule #8 Consider the implications of tax

Interest is taxable as are capital gains. However, there are both annual interest and capital gains exemptions available to individual tax payers. Utilise such tax allowances before investing in tax structured products. Retirement fund wrappers like Retirement Annuities and Preservation funds offer a total shield against all taxes on interest and capital gains made within such structures.

Rule #9 Remember the power of compounding

This applies both to the length of time funds are invested and to the interest rate achieved which drives growth. To maximise the power of compounding re-invest distributions where possible.

Rule #10 Consider the effects of inflation

Inflation is the enemy of the investor and can make investing like paddling upstream. If yields are lower than inflation then real returns are not being achieved and the investor is effectively going backwards. Do not remain in income investments that do not generate a real return for too long in order to minimise wealth erosion.