Ten rules for income investing
In an environment where investment returns are becoming increasingly strained, many investors could be tempted to chase yield. This however is a very dangerous investment strategy as it often fails to take the associated risk into account.
Sean Segar, Head of Nedgroup Investments Cash Solutions, provides the following rules to guide investors to avoid potential investment traps:
Rule #1 Use the risk-free rate as the base reference point
The risk-free rate is the yield on government paper for the comparable period, and is efficiently determined by the market. Therefore, once the risk-free rate has been established, it is easier for investors to assess if additional yield is worth the additional risk. Be wary of outliers on this spectrum and avoid investing where the risk appears disproportionate to the yield.
The main types of risk to consider are:
- Credit risk: This is the risk that a borrower may not repay a loan and that the lender may lose the principal of the loan or the interest associated with it.
- Liquidity risk: This risk occurs when an individual investor, business or financial institution cannot meet short-term debt obligations. For example, the investor or entity may be unable to convert an asset into cash without giving up capital and/or income due to a lack of buyers or an inefficient market.
- Interest rate risk: This is the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship.
Rule #2 Understand what you are investing in
- When investing in an interest paying instrument ensure you understand the following:
- A guarantee is only as good as the entity issuing the guarantee. Understanding the strength of the guarantee is crucial as certain guarantees are worth very little. A common mistake is to assume that nothing can go wrong simply because a deposit is guaranteed.
- Understand if the rate quoted is effective or nominal, and if it is net or gross of fees.
- Ensure costs are reasonable. Income type funds should typically be cheaper than equity and balanced funds.
- Ensure there are no once off costs to buy or sell income bearing investments. These can distort net yields enormously, especially for shorter dated income investments. For example, a 1% fee to enter a six month investment yielding an annual rate of 8% results in a net annualised yield of only 6% over the period of the investment.
- Before investing in an income fund, review the investment mandate to ensure that this does not permit investment in instruments you are not comfortable with. For example some income funds are permitted to invest in property, preference shares, offshore currencies, non-investment grade credit, or very long dated bonds. All of these instruments can offer generous yields - but they also come with a higher risk of capital fluctuations.
- Avoid fads and look beyond the marketing message. Rely on the data and talk to a financial advisor for guidance.
- Understand the regulatory environment of the product and the issuer and be clear that you are investing legally and ethically.
Rule #3 Make use of pooled income funds
Pooled investment funds are convenient and offer the following advantages:
- Higher yields than call accounts, but access to funds is similar to being on call
- Spread of counterparty credit risk through diversification of investments held in the fund
- Ability to invest in longer dated instruments at higher yields but still having easy access to funds
- Unit trusts are regulated and in many cases rated by independent rating agencies, offering an additional level of comfort to investors
- Professional, specialist investment management
- Minimum investment amounts are relatively low, or even zero when the investor has no surplus cash to invest, unlike direct investments where the top interest rate is only earned by the largest of investors, or the interest rate is subject to a minimum balance or minimum term
- The scale that unit income unit trusts have keeps fees low and provides the fund with buying power with banks and other issuers. Small investors invest alongside large ones with the same benefits.
- There are no transacting fees, low investment management fees, and fees are only applicable while funds are invested
Be comfortable with the investment mandate and the investment manager of any income fund. Ensure that they are reputable; credible, their investment philosophy is sound; they have a robust process; the team is suitably qualified and experienced with a good track record and finally; that the track record belongs to current team/individual manager.
Rule #4 Ensure that you have suitable access to your money
It is always tempting to earn higher yields by fixing investments for a set term. However, should you for some reason need to draw on such funds there are likely to be penalties. So the lesson is: If you make fixed term investments ensure that you will not require the funds over the life of that term and do not “lock up” your funds if you may need access to them. Fixing a deposit term for higher yield may backfire.
Rule #5 Match income receipt dates to your needs
Taking Rule #4 a step further, ensure that the frequency of the income distributions of the investment is in line with your needs. It will create unnecessary administration and even penalties should you have to tap into the investment’s capital to fund cash flow requirements. Some investments only distribute every six months or at the end of the investment term. On the other hand, should an investment distribute income more frequently than you require, reinvest this income rather than draw it unnecessarily. This will allow for compounding of returns and ensure you are not tempted to waste these funds. Always favour steady, predictable income streams.
Rule #6 Don’t leave cash on one-day call unless you really might need it in one day
Ensure potential yield is not being sacrificed for the luxury of having immediate access to funds, which in fact is not really needed. The yield on daily call monies is lower than that on funds placed for fixed term because it is immediately accessible. Unless funds are possibly required at short notice, cash should be put to work without forfeiting potential yield uplift until it is required to be deployed. This simple planning of future cash flow requirements enables funds to be better deployed. It is worth spending some time forecasting cash requirements to ensure optimal investing, and sweeping cash into funds from inefficient current or call accounts into appropriate higher yielding vehicles. The incremental interest adds up fast and the discipline of efficiency becomes entrenched behaviour.
Rule #7 Don’t be too conservative
There is such a thing as being too conservative. Most people can afford to take on an element of risk for which they should be appropriately rewarded through higher interest rates. Understand your level of risk tolerance and apply it. A financial advisor can provide valuable assistance in assessing your investment risk profile before you decide where and how to invest.
Rule #8 Consider the implications of tax
Interest is taxable as are capital gains. However, there are both annual interest and capital gains exemptions available to individual tax payers. Utilise such tax allowances before investing in tax structured products. Retirement fund wrappers like Retirement Annuities and Preservation funds offer a total shield against all taxes on interest and capital gains made within such structures. Use of Tax-Free investments is also a very attractive tool here and should also be maximised by individuals.
Rule #9 Remember the power of compounding, but also the effects of inflation
This applies both to the length of time that funds are invested and to the interest rate achieved which drives growth. To maximise the power of compounding re-invest distributions where possible. Of course inflation is the enemy of the investor, and also compounds. This can make investing feel like paddling upstream. If yields are lower than inflation then real returns are not being achieved and the investor is effectively going backwards in real terms.
Do not remain in income investments that do not generate inflation beating returns for too long. In volatile and uncertain times, even inflationary times, it may make sense to park funds in cash until normality resumes. Even though yields may not be above inflation, or returns potentially as high as other asset classes, at least the investment will be liquid, the capital is likely to remain intact, and a positive return should be achieved being the interest received.
Rule #10 Pay off high cost debt before investing for interest
Interest paid will almost always exceed interest earned, especially after tax. The best interest rate is therefore the saving that can be achieved by paying down debt. Always consider first paying off debt before beginning to invest for interest.