Investing for income in a falling interest rate environment

Interest rates have been slashed back to the October 2006 level over the course of just six months, requiring investors to reconsider their investment strategies where income generation is the focus.

Investors focused mainly on generating an income from their investments have been well rewarded by money market funds over the past year, with these funds generating double-digit returns and outperforming most other types of unit trusts.

However, with interest rates already having fallen by some 350 basis points since December 2008 and expected to fall further this year, it is becoming increasingly difficult for income investors to generate an income that will beat inflation over the longer term.

Beyond the money market

Pieter Hugo, MD of Old Mutual Unit Trusts, advises income investors with a somewhat longer-term view to consider unit trusts like diversified income funds as a way to enhance their returns beyond the money market. "The average money market fund return peaked at 13.5% per year in December,by February this had fallen to 10.7% per year," notes Hugo. "These were excellent nominal returns. But while these funds might still offer safety and relatively attractive returns".

"But while these funds might still offer safety and relatively attractive returns over the short term, investors with a somewhat longer-term view, say 12 to 18 months, now need to look for alternative, more diversified unit trusts to generate an income that outpaces inflation over time."

Investors in money market funds are experiencing a falling yield on their investments, as the interest rate paid on these funds is linked to the South African Reserve Bank's repurchase (repo) rate. Money market funds typically invest in short-term instruments like Negotiated Certificates of Deposits, Bankers Acceptances and government bills, with an average duration of only 90 days.

Diversified solutions

Investors looking to grow their incomes over time may benefit from including other income solutions like diversified income funds in their portfolio, says Hugo. In contrast to money market funds, diversified income funds can invest in additional types of income-generating assets, like government and corporate bonds, inflation-linked bonds, preference shares, listed property and other high-yield income securities.

Risk profile

Such funds do carry marginally more risk than money market funds, but they are still much less risky than the typical balanced (multi-asset class) fund. Typically, the exposure to riskier assets is also kept within tightly defined limits, further helping to manage overall portfolio risk.

There are many income funds out there for income-focused investors to choose from, depending on their risk tolerance. "I would urge that if you are looking for income, choose one of the more diversified funds over a money market fund if your risk profile allows it – they are likely to have better chances of outpacing inflation in the long run," says Hugo.