Communication

Chasing yield alone leads to high risk

By AMP Capital

When thinking about how to retire comfortably, about a third of SMSF trustees say their top goal is building a sustainable income stream, however chasing this very strategy can cause them to take on too much risk.

Weighing up whether rewards are worth the risk is something people do most of their lives: be it a toddler sneaking a cookie from the jar when the parents aren’t looking, to the retirement years when SMSF trustees consider whether to weight their portfolio to shares, bonds, property, infrastructure, or something else.

The decision an SMSF trustee makes should depend on their own personal retirement goals. It’s essential to regularly monitor and reassess your assets and determine whether you’ve got the right mix to meet your income requirements, without taking on more risk than you need to.

With so many trustees sharing a common goal (building a sustainable income stream) over the past five years, the hunt for yield has been relentless. As a result, we’ve seen two things happen:

  1. Valuations become increasingly expensive - for investors to receive an income, they have to put more capital at risk.
  2. Income levels fall - particularly from the ‘risk-free’ parts of the market, which become expensive and underperform (ie. government bonds and term deposits), which means investors have to look for income outside of defensive asset classes.

That means, simply chasing yield can be a trap. You may end up taking on more risk than you’re comfortable with, for an income that isn’t sustainable.

That’s why it’s more important than ever to really understand the source and sustainability of your portfolio’s income and to diversify across different income-producing asset classes - but not at any price.

How to find the right balance

Each SMSF investor will have their own “right” balance of income-producing investments. Once you’re clear about your income strategy, you can start to find the right assets that meet your criteria.

Here are some tips to avoid falling into the income trap with different types of assets:

Shares

Simply identifying stocks that pay high dividends can be a risky strategy unless you understand the reasons why the company is paying a dividend. For example, if the company has sold an asset to maintain the payout to shareholders this may be a sign dividends are not sustainable.

Other indicators of an unsustainable dividend include low returns, volatile earnings, poor momentum, high payout ratios, and the use of borrowing to finance dividends.

Rather than simply focusing on yield, consider the total benefits the stock may bring to your portfolio. For example, the tax-effectiveness of franking credits are very attractive to income-seeking SMSF investors. With that in mind, consider searching for companies that have the potential to conduct off-market buy-backs in the near future.

Bonds

Bonds generally provide higher expected returns than cash and term deposits and are at the lower end of the risk spectrum.

However, SMSF trustees need to understand the relationship between the asset’s worth and its income as the investment’s value changes in response to bond yields. If yields fall the investment’s value will rise because it won’t have to pay out as much to investors. But if yields rise, asset values lag.

Interest rates are one of the important variables that contribute to returns. As rates rise, returns fall as this increases the amount the asset has to give back to investors. If the global economy continues to pick up pace and interest rates start to rise, bond yields could rise further, which could lead to capital losses on these investments.

However, in Australia at the moment the AMP Capital view is that bonds will remain on hold until at least 2020.

The message here is to do your research on market conditions on a regular basis.

SMSF trustees generally access the bond market by investing in managed funds, so be mindful of fees and risks. The AMP Capital Corporate Bond Fund is an example of a managed fund which offers investors access to a diversified portfolio of investment grade bonds.

Infrastructure

Infrastructure assets can provide consistent long-term income yields because their revenues are often underpinned by regulation or by long-term contracts, commonly with governments. This means infrastructure assets often offer visibility and security when it comes to their future revenues.

However, there are some variables that could impact the performance of infrastructure assets. For instance, many assets carry high levels of debt. So as interest rates rise so too do borrowing costs, which can affect returns. Make sure you understand how these variables can impact return.

Like bonds, investors generally access infrastructure assets by investing in managed funds.

It’s also important for investors in global infrastructure investments to take into account any effect the currency may have on their assets’ return. There will be a small cost associated with hedging away currency risk by investing in a hedged managed fund for example, which may also impact potential returns.

The AMP Capital Core Infrastructure Fund is an example of a managed fund which comprises of a portfolio of high-quality listed and unlisted infrastructure assets in Australia and globally.

Property

Australians' love affair with property is well known. However, some of the considerations for SMSF trustees is the right split of commercial property and residential real estate assets in their fund, how this balances with their assets outside of super, as well as whether to get exposure through listed or unlisted vehicles.
Commercial property in particular can be prohibitively expensive for individuals to invest in on their own, so choosing how to get exposure needs careful consideration.

AREITs and REITs, which are trusts that hold a basket of diversified commercial properties, are some of the most popular ways to get access to listed commercial properties. It’s also possible to buy into assets directly. Another option is to buy shares in listed property companies.

For unlisted commercial property, the options available depend on how much an investor has to invest. Three of the most accessible are direct ownership, syndicates, and open-ended funds.

Liquidity is the advantage that listed properties have over their non-listed counterparts, which means shares in them are easier to buy and sell than shares or units in other property assets such as direct commercial property. But listed assets are also exposed to share market movements. It’s important to consider the impact that adding listed property will have to the overall volatility of your portfolio. When markets fall, most sectors get swept up in the carnage.

Many listed commercial property investments such as global REITs have an interest in properties held outside Australia, which can bring diversification benefits. However, SMSF trustees must consider any currency impact on their investment should they decide to invest in offshore property.

The AMP Capital Wholesale Australian Property Fund offers investors access to a diversified portfolio of high-quality Australian commercial properties.

In summary...

It’s essential to continually monitor and reassess your assets, and determine whether you’ve got the right mix to meet your income requirements, without taking on more risk than you need to. By simply chasing yield, you may be subjecting your portfolio to unnecessary risk.

Regularly review your strategy to ensure it remains relevant for the current market conditions.

 

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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