Five risks of a low rates era

Low interest rates have eroded cash returns … but high-yield alternatives can be very risky.

Summary: Investors seeking to offset their low returns from cash can be seduced by the high-yield returns on offer from shares and other assets, including property. The problem is, high-yield generally equates to higher risk. It’s therefore important to look very closely before you leap out of the cash safety zone.
Key take-out: Cash still has a role in dampening volatility in a portfolio, and its liquidity allows for opportunistic investments in other assets that have fallen in value.
Key beneficiaries: General investors. Category: Asset allocation.

There have been so many challenges for investors over the past seven years – punctuated by the Australian sharemarket falling 50% and the Australia dollar moving from a low range against the US dollar to well over parity.

A more subtle – but still crucial – change in the investment landscape has been the fall in the cash rate to 2.5%. There are a cascade of challenges that this causes for investors, not least that those relying on cash returns for income will be struggling to make ends meet. Five or six years ago there were term deposits offering returns of 8% over a five-year term. That return has since more than halved.

It’s not hard to paint a picture of how tough things for investors stuck in cash are. Many people will only be earning rates of 3.75% on their cash. If they are retired, and withdrawing money from their portfolio at a rate of 4%, they are going backwards. Factor in inflation of 2.5%, and the real value of their assets is going backwards at a rate of 2.75% a year. It’s a tough situation to be in.

There are important impacts of a very low cash rate and its effect on investor decisions that investors should be aware of – five in particular that I want to highlight here.

Issue 1 – The temptation to hunt aggressively for sharemarket yield

Bank shares and Telstra are offering gross yields of around 8%, compared to cash rates of 4%. Surely the correct move is load up on high-income paying shares?

While the answer for most people will be a mix of cash assets and sharemarket exposure, a lurch to high-income paying shares might not be the best strategy. Let’s take a couple of yield favourites – Telstra and Commonwealth Bank. Telstra is $5.07 today. Just over 18 months ago it was around $3. Today Commonwealth Bank closed above $71. Just over 18 months ago it was $43.

These yield favourites, like so many shares with similar attributes, have had stellar price gains over the last two years – outperforming the overall market. Part of their great returns are likely to have been from investors leaving cash and seeking yield in shares – pushing their prices up. This means that the real value in the strategy has likely passed, so jumping in now certainly seems to be chasing returns.

A related issue to this is that companies might be inclined to increase their dividends, without having the earnings to support the dividends, to attract yield-hungry investors. Investors need to keep an eye on the dividend cover of the companies that they own, making sure that dividends are being paid out of legitimate cash earnings.

Issue 2 – High-yield investments

The wreckage of investment schemes offering high fixed-yield returns (such as Westpoint and Fincorp) should still be recent in the minds of well-informed investors. Promoters of ‘non-mainstream’ investments that promise high rates of ‘reliable’ income could be starting to look like a better investment to some.

But it’s time to stay cynical. Investments away from the traditional asset classes of cash, shares and property should always be researched thoroughly. When investments offer a return above the cash rate of return (say 3% to 4% at the moment), there is a reason they have to offer those high returns – they are risky. Be cautious around any such offering.

Issue 3 – Gearing into shares

With cash rates so extraordinarily low, and the yield on the sharemarket comparatively attractive, those people who make their money out of encouraging you to borrow money and invest in shares can put together a pretty compelling argument. The gross income from shares at the moment will roughly equal the cost of borrowing – what could go wrong?

It’s a rhetorical question (it must be all the politicians campaigning that inspired that in me). Actually, there are a lot of things could go wrong.

The shares you own could fall sharply in value, while you are left with a big loan. The biggest falls in the Australian sharemarket have been around 50% (during the GFC, 1987, 1970s and the Great Depression) – and chances are it will happen again sometime in the future.

Interest rates could rise sharply – meaning that repayments might be much higher than the income from the shares. This does not seem likely at the moment – but keep in mind that Australian interest rates were well above 15% in the early 1980s and again in the early 1990s.

And keep in mind that there are structural issues with margin loans that you should be aware of – high interest costs, possible changes in lending against shares over time, the need to stump up more shares or cash if your shares fall in value and you get a ‘margin call’.

The people encouraging you to gear into shares probably have an incentive to encourage you to do that, so make sure you keep your own best interests firmly in mind.

Issue 4 – Comparative valuations – But don’t forget cash

Suddenly the yield from property and share-based investments seem more attractive than the income from cash – and in some ways that is true. Given the capacity for dividends and rental income to increase over time, they are an important part of most people’s portfolios.

However, it is not time to turn our back on cash completely. Firstly, cash (or cash-like investments like term deposits) plays a crucial role in providing liquidity in a portfolio. If there are cash needs that you have over the next five-seven years, cash remains a great option for this money. Putting money into growth assets for a period of time like this is risky – cash still has a place for liquidity.

Further, cash still has a role in dampening volatility in a portfolio. It allows for opportunistic investments if shares or property have fallen in value, as while returns are currently low, it’s likely they will recover in the future.

Issue 5 – Aggressively marketed property schemes

The poor returns from cash will be another weapon for people spruiking aggressively marketed property schemes – including to self-managed super fund investors. You can probably hear their pitches now – “shares are too risky, look at what happened to them during the GFC, cash earnings are historically low … you need the safety of bricks and mortar and it has never been cheaper to borrow”.

It’s an important time to seek high-quality independent advice about investment decisions – not fall for the slick marketing patter of a spruiker using the low cash rate as another reason to buy, buy, buy.

Conclusion

The sharemarket ‘crash’ following the GFC was dramatic. The repeated cutting of the cash rate from above 7% to 2.5% has been far less dramatic, but this is still a challenge for investors.

Cash is likely to have an important role in most portfolios, and staying away from dramatic portfolio decisions is likely to be part of managing this challenging situation.


Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.