Challenges for investors in a flat environment

Here's the situation. A historical low cash rate of 1.25 per cent, against the RBA calculation of inflation at 1.3 per cent, and suddenly, investing at the cash rate becomes a ‘risk-free’ way to decrease the purchasing power of your money. 

A flat yield curve means there is little joy in just moving to longer term fixed interest investments. At a practical level, this means the 5-year term deposits of the Big Four banks are paying around 2 per cent.  

The question for investors – what to do from here, given this unique set of circumstances?

The continued important role of cash and fixed interest

Even though the investment returns from fixed interest and cash investments will likely remain low, it is important to keep in mind that these investments have a role in a portfolio beyond just providing returns.   

They are generally the key sources of liquidity (ready access to cash if needed) in a portfolio, and also dampen overall portfolio volatility. 

Even in the current environment, where the expected returns from cash and fixed interest are at record lows, there remains a strong argument to still retain these assets in your portfolio as per your strategic, long-term asset allocation plan.

Another challenge for investors will be to not give in to fixed interest style investments offering high yields. As we are now about 10 years on from the worse of the GFC, memories of the failed mezzanine finance schemes of the time, promoted offering high yields, have started to fade. 

Looking for higher yield, and taking on more risk, in the fixed interest part of your portfolio can be very problematic. After all, your cash and fixed interest investments should be the lowest risk parts of your portfolio. 

The old saying that ‘cash lets you sleep, shares let you eat’ remains relevant, even in a low interest rate environment.

'Duration' of your investments

One thing to consider about the bond/fixed interest side of your portfolio is its 'duration'. This effectively is a measure of the weighted average of the cash flows from a fixed interest investment. For example, a 5-year term deposit paying six monthly interest payments will have a longer duration than a 3-year term deposit paying six monthly interest payments.

The practical application of ‘duration’ in a fixed interest portfolio is, the longer the duration of a bond portfolio, the more sensitive its value is to interest rate movements. If interest rates are falling, a long duration portfolio is generally better because bond prices are increasing. As interest rates rise, the opposite is true. This is where an investor might take a more involved approach to their portfolio. 

Given how low interest rates are right now, moving more of these cash and fixed interest assets into cash and shorter duration fixed interest investments (such as shorter term deposits), and waiting until interest rates are more attractive before committing to longer duration fixed interest investments, might be a strategy for some investors to consider.

Another key element that low interest rates emphasise is the importance of keeping costs reasonable in the fixed interest part of your portfolio. 

This does not just include the direct costs of a fixed interest investment, for example, managed fund fees. 

It might also include other fees being paid on a portfolio, such as an advisor fee of 0.5 per cent and/or a portfolio administration fee of 0.5 per cent on your investments. 

With current low interest rates, you can expect a major part of the returns from your cash/fixed interest investments to be immediately absorbed by fees, before even considering the impact of inflation. 

Low cash rate and growth assets

One way of looking at the values of other investments is the idea that ‘risky’ investments reward investors with a ‘market risk premium’. 

The market risk premium is an additional return over the risk-free return that exists in an economy. An Australian Government-backed bond would be considered a risk-free asset.

We might talk about shares, for example, having a market risk premium of 5 per cent. (Estimates of the market risk premium in Australia using historical data seem to range from about 4.5 per cent to 7 per cent.)

This implies that if the risk-free rate in the economy is, say, 6 per cent, the total return from shares will be this 6 per cent, plus the market risk premium of 5 per cent. That's a total return of 11 per cent, which is pretty consistent with the long run total return from shares.

However, with the risk-free rate in the Australian economy currently around 1.5 per cent, the current expected return from shares would be a total return of 6.5 per cent. 

With such low interest rates, even if growth assets like shares provide a healthy ‘market risk premium’, the total returns are not likely to be as attractive as they have been historically. (Macquarie University has a paper that looks further at the topic of market risk premiums here.)

A more intuitive way to look at this may be to consider that an investor has any number of options when investing, including the choices between cash, shares and property. 

Because the return on cash is currently lower, more people will look to shares and property as investments in the hope of a higher return, which in turn pushes their prices higher and reduces their expected future returns.

It is worth keeping this in mind when thinking about forming realistic expectations of future returns from growth assets.

Getting the balance right

Clearly, cash and fixed interest investments continue to play an important role in terms of providing liquidity and dampening overall portfolio volatility in a low interest rate environment. 

With rates at these levels, it is worth thinking about the balance of fixed interest and cash investments in a portfolio, and considering if or when it might be the right time to hold shorter-duration assets. 

As well as impacting the direct returns from cash style investments, a low cash rate may also lead to slightly lower returns from growth assets, which is just another element to keep in mind.