Sensible advice for “near cash” investments

Most investors understand that a diversified investment portfolio is a prudent investment strategy. What is sometimes less evident is that additional diversification within the fixed interest or income-oriented portion of a portfolio is important too.

The financial services industry, aware of the need investors have for positive real returns from income-oriented investments, has created a myriad of income products for investors to choose from. This means that the decision is far from the "cash versus bonds” choice it used to be.

There are also forces at play that make it difficult for individual investors to make these decisions. Some of today’s complex products require a level of information access not always available to the average investor, while others have high barriers to entry, including substantial minimum investment criteria.

How can financial advisors best advise their clients when it comes to income-oriented investments? It is worth considering the following factors before choosing a financial instrument to suit your clients’ needs:

While most fixed-rate investment products offer a measure of stability they tend to be inflexible should the economic situation change. Corporate or government bonds offering a nominal income growth of 6.5% or 7.5%, a great idea in a sub-6% inflation environment, will not keep pace if inflation creeps up to 8% or worse. Investors should be wary of making long-term investments at fixed nominal rates, especially when the investment cannot be readily exited when the macroeconomic environment changes.

One way to combat the inflexibility of fixed-interest vehicles is to select an inflation-linked bond. This would provide a suitable hedge for inflation. However, caution should still be exercised and investors should make sure that the pricing of such vehicles makes sense.

A study of the long-term trend in South African real interest rates (interest rates less inflation) suggests that real income growth in the order of 2.5% is realistic. It also reveals that the unusually high real interest rates achieved over the past decade are unsustainable. A tough economic climate means that investors should be wary of any fixed-interest product that promises more than 2.5% real return per annum. By chasing higher real returns you could unknowingly place your clients’ capital at risk.

Investors mistakenly believe that high-yielding, income-oriented instruments with a lower duration will minimise their investment risk. Minimising interest rate risk is not the be-all and end-all of income investing. Default risk – the risk that a borrower will default on its obligation to lenders – may generate a premium interest rate, but it remains a risk nevertheless!

Concentration risk is not understood either. This risk stems from the allocation of too much of a portfolio to a single investment, as often happens with a property development or a single large investment into a corporate bond or preference share scheme.

Too many unsuspecting income investors are attracted by the promise of high income growth, only to lose sight of the concentration risk associated with single large investments. They should guard against this by diversifying their portfolios, spreading their savings among many unrelated investments.

Professional investors enjoy an information advantage over the general investing public. This is more pervasive in less regulated sections of the financial markets – such as Property syndications, unlisted debt and the interest rate derivative market – where many income-oriented investors are concentrated.

Investors and advisors should insist on complete transparency on fees, indirect costs, investment decisions, sources of return and accounting and valuation policies, to minimise the risks associated with the unequal distribution of information.

By investing your clients in a well-diversified income-oriented portfolio you will maximise their real income growth and minimise their risk.