The risk of finding income in a low-interest-rate world

As global interest rates sink to near zero or below, the search for regular income has become increasingly desperate. But, according to Mint Asset Management’s David Boyle, yield-oriented investors must remember that “certainty” can come at a high cost ...

Tuesday, June 2nd 2020, 9:41AM

by Mint Asset Management

David Boyle

In May 2006 the last great wave of NZ finance company collapses began to surge in a swell that would ultimately carry away $3 billion plus of retail investor capital in its backwash.

A recent memory, perhaps, but 14 years is long enough for many investors to forget the details. Less than a year after one of the final GFC-era finance company legal cases closed in a guilty verdict (Viaduct Capital) last August, a new collapse splashed into headlines.

FE Investments, one of the few to survive the earlier NZ finance company rout, fell into receivership this April leaving the fate of over $54 million of retail investor deposits in doubt.

The FE failure is unlikely to trigger a second wave of finance company collapses for the simple fact that only a handful continue to operate in NZ. However, the investment promise that FE and finance companies of old thrived on remains alive and well in NZ.

Like finance companies, other investment products ranging from mortgage-backed funds to commercial property syndicates are pitching to retail investors a fixed rate of return above bank term deposits but with the same allure of safety.

Posting a relatively high yield (5% or thereabouts is enough in the current era) does the trick of anchoring investors to apparent certainty.

The VUA view: seeing beyond the certain horizon

As the many thousands of earlier finance company investors discovered, “certainty” can quickly morph into shocked disappointment when conditions change.

More seasoned investors understand that markets deal in the opposite of certainty, to varying degrees. And those probabilities also vary through time according to backdrop circumstances, which today are more riddled with doubt than ever.

Rather than fixing expectations to a random number, investors need a more flexible model to navigate through a rapidly changing world. For example, VUCA – an acronym first coined in Harvard Business School – offers a realistic framework for how markets operate.

VUCA reminds investors to view the world through the lens of four key concepts: volatility; uncertainty; complexity; and ambiguity.

While the four corners of the VUCA frame are inter-related, they separately highlight subtle features of real market conditions and investor emotions.

For Mint, applying VUCA thinking helps us address both the investment challenges of the day and the needs of our clients.

Specifically, in regards to finding income in a low-rate environment, the VUCA model helps sharpen our focus on where the true risks and opportunities lie – and why some investors may be oblivious to the dangers lurking in products advertising high fixed yields.

High tide for risk as rates recede

Low rates are here to stay for some time. Central banks around the world, including the Reserve Bank of NZ (RBNZ), have seen to that.

In its May Monetary Policy Statement, the RBNZ makes explicit what the drive to ultra-low (maybe sub-zero) rates by both conventional (cutting the OCR) and unconventional (quantitative easing) measures will mean for the broader investment universe.

“As the return on lower-risk assets is reduced, the relative return on riskier assets becomes more attractive to investors,” the RBNZ statement says. “Investors are incentivised to rebalance their investments into riskier assets, thereby reducing the risk premiums of these assets as well.”

But are investors, especially those weighted to more conservative income products, ready to accurately assess the extra risks coming their way? The rise of “alternative” fixed rate products undoubtedly increases the likelihood of mistakes and risk mismatches for inexperienced or unadvised yield-hunters.

In particular, if investors switch from diversified income funds (or even bank term deposits) to high-yield alternatives they need to understand the underlying product risks.

For example, selling managed funds, which offer daily liquidity, to invest in term products touting a putatively high “fixed” yield could see investors punished with the double whammy of crystalising losses and losing access to their money (possibly for ever).

Stay safe: why diversification still rules

Across the Tasman this May, the Australian Securities and Investments Commission (ASIC) warned investors to be wary following a recent “surge in such marketing of fixed-term investment products”.

ASIC deputy chair, Karen Chester, said in a release: “In the current uncertain and volatile markets, higher risk investment products are, more than ever, not for everyone. Especially for smaller investors, be they retail or wholesale, when they are not investing as part of a diversified portfolio.

“Be wary of investments that claim to be ‘like’ a ‘term deposit’. Products spruiking even a two or three percentage point higher return than a term deposit represent significantly higher risk. We are also seeing products offering only marginally higher returns with much higher risk profiles.”

The ASIC warning applies equally to the NZ market. It’s also a reminder that good financial advice is more important than ever as record low returns on so-called “safe” financial assets force investors up the risk scale.

Financial advisers are also keeping a close eye on the risk fund managers are taking in their income products. Mint, for one, is sticking to its risk-weighted process in selecting securities for the Diversified Income Fund, rather than chasing yield. The rising probability of corporate bond defaults, for instance, makes active security selection and diversification even more critical in the fixed interest space.

Despite the lower overall returns available across all markets (a trend made more VUCA-ful by Covid-19), a diversified portfolio of high-quality bonds, credit and dividend-bearing stocks can still deliver income – along with the possibility of capital gains – without getting into dangerous waters.

Mint Asset Management is an independent investment management business based in Auckland, New Zealand. Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement at mintasset.co.nz

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