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Limiting Investment Risk

Safety used to pay little… but now pays virtually nothing.  Interest rates have never been so low.  Australia’s cash rate is now 0.75% p.a.; 10 year Government bonds were around 5% in 2011 but are now around 1% p.a.  Many Japanese and European bond rates are now negative.  One Danish bank even offers negative home mortgage rates!  While good for borrowers, it’s tough for retirees seeking income – they’re being pushed to take more risk.

About 25% of global debt now earns negative rates – is it sustainable for investors pay for the privilege of lending their savings to others?   A bond with negative yield, gives you back less than you invested… no interest is paid.  So, why buy one?  Is it to preserve your capital?  That depends on the bond issuer’s reliability.  Maybe you think rates will go even lower or that alternatives to Government bonds are riskier.

Australian rates are higher than Europe or Japan’s negative levels and though we’re unlikely to go that low, rates may stay low for many years.

Most investors prefer to take a bit more risk than to accept low deposit/bond returns.  Corporate bonds offer a credit risk margin above the base rate and there’s also low risk property and infrastructure.  Even so, we expect lower portfolio returns in the next few years because everything is rated against the risk-free cash rate (now 0.75% in Australia).

Meanwhile, rate cuts just cheer up the stock market. Falling interest rates have pushed up returns and the price of ‘growth’ assets.  Much of the US stock market is now overpriced.  From current prices, the overall US stock market might only deliver 3% p.a. over the next 10 years.  In such markets, bonds are normally a good risk diversifier… yet the bond market itself seems overpriced.  The graph below shows relative value vs history

Now more than ever, asset decisions depend on robust valuations, liquidity, sentiment and clarity about where we are in the business cycle.  There is a global recession risk now but it’s probably unlikely until after 2020 as it would be a re-election disaster for Trump.  As it’s almost 30 years since Australia’s last recession, most Aussies have no experience.

How did we reach such unprecedented interest rate territory?  The Bear Stearns Hedge fund collapse and subsequent Lehmann Brothers bankruptcy triggered the 2008 Global Financial Crisis.  The US Central bank (‘Fed’) then began unprecedented rate cuts from 5.25% to 1.75% now.  We’ve never had US bond yields this low while PEs are so high.  Is it different this time or is this a bleak choice between low rates or possible US stock market drop?

This unchartered territory gives conservative investors difficult choices.  Stock valuations are high and bond yields low, so traditional diversification may not help. Is this a time for alternatives?

While sapping long term returns, assets used for hedging against falling markets include:

  • Cash for capital safety and the option of buying at lower prices.
  • Gold for improved outcomes amid political uncertainty or rising inflation.
  • Government Bonds to prosper in a flight to safety or against inflation risk.
  • Holding options that rise in value when an underlying asset value falls.

Keeping extra cash till well-priced, quality assets appear is a juggle.  Waiting too long for them while earning low rates, can be expensive – yet patiently tolerating slow patches usually pays off.  Until then, seek income from quality, easily-sold assets.

Compared with 12 month bank deposits Australian share dividends and directly held commercial property have not fallen as much.  Dividend yields are in their normal range – so like commercial property they seem to offer better value, as does global infrastructure.

Does diversifying across all asset classes (Government and corporate debt, large and small stocks, emerging and developed economies) still diminish risk?  Is it still vulnerable to severe market falls? What risk are you taking if you proceed up the risk/return range?

Stock market investment raises the chance of losing capital but history shows it can offer high, stable income as long as you’re prepared to be patient – income being about half the total return. The graph below illustrates this, even excluding the franking credits on share dividends since 1988.

So a diversified portfolio including Australian shares can offer stable, growing income compared with bank deposits.  Is stability in your portfolio value more important to you than income?  A well-diversified share portfolio can pay you high, sustainable dividend income but it takes confidence and fortitude. It is in this area that a good adviser can add huge value.

Learn how to invest in a low rate world at our seminar in Urrbrae House on 6th November 2019

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Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.