Fixed interest temptations

It seems a statement of the obvious to start this article by saying that these are challenging times for an investor looking for income from their portfolio.

Australian share income has fallen during the COVID-19 downturn, and with the Reserve Bank of Australia cash rate at 0.1 per cent, returns from fixed interest and cash investments are skinny at best.

An environment like this can provide temptations for investors to seek more risk in the ‘fixed interest’ portion of their portfolios, in the pursuit of higher returns.

This is similar to what we saw during the Global Financial Crisis, with investors chasing advertised yields through investments like Westpoint and Fincorp, investments that ultimately failed and cost investors dearly.

The important role of fixed interest investments in a portfolio

There is a great investment saying – ‘shares let you eat, cash lets you sleep’. Let’s include with cash the fixed interest part of an investment portfolio, as a reminder of what we are looking for with these investments.

The first is liquidity. The cash/fixed interest part of the portfolio should have funds easily accessible if money is needed. Even term deposits can be accessed at relatively short notice if needed, albeit that there may be some associated costs/loss of interest.

The second is that the cash/fixed interest part of the portfolio should dampen portfolio volatility. Even as shares fell in value by around 40 per cent last year, high quality cash/fixed interest investments should have retained their value.

The third is quality. The structure of fixed interest investments means they have a higher claim on the assets of a business compared to a shareholder in the case of financial distress, and a diversified portfolio of investment-grade instruments (rated BBB or better by Standards and Poor’s) will have a strong capacity to meet the financial commitments of paying income and repaying the capital when it is due.

Liquidity, dampening volatility, and exposure to quality assets are all important in ‘letting you sleep’ as an investor – without mentioning the additional investment return, admittedly skinny at the moment, from this investment class.

What about a 5% fixed income opportunity?

There seem to be more and more ‘fixed interest’ opportunities being advertised at the moment – offering a higher income return with the advertising promise of a fixed income return.

One of these is the Skyring Fixed Income Fund – offering a very attractive income return of 5.85 per cent per annum.

The profound relationship between risk and return – and a look at credit quality

Let’s start by considering a 5.85 per cent return.

In a low inflation, low interest rate environment, this is an attractive return – somewhere around 5 per cent better than the rate of return from cash and well above the rate of inflation.

Let’s consider how a return of 5.85 per cent per annum is generated – and here, for me, is one of the profound relationships of investing.

As an investor, my rate of return is the other parties ‘cost of capital’.

For me to earn a return of 5.85 per cent (actually 6.62 per cent when the 0.77 per cent fund management fee is taken into account), someone is paying Skyring at least 6.62 per cent per annum to borrow the money.

Given that my mortgage is currently 2 per cent per annum, someone paying 6.62 per cent for borrowed money is only paying that because they have not been able to find someone to lend them money at 2 per cent, or 3 per cent, or 4 per cent or 5 per cent or 6 per cent; there would seem to be some risks associated with the activities to have to borrow money at 6.62 per cent or higher.

The PDS discloses that all loans made actually have an interest rate of 9 per cent or higher – suggesting that there are reasonable risks associated with these high interest loans.

Indeed, an investor receiving a 5.85 per cent return for loans made with an interest rate of more than 9 per cent might query whether they are being fairly compensated, although the fund does hold some cash which would lower the risk profile.

Skyring sets out that loans are for property purchase, property development, business growth and business acquisition, with the loans for business growth and acquisitions secured by assets of the borrower, not first mortgages over real property. There is no credit rating associated with the investment, which would usually be a key indicator of the quality of a fixed interest investment.

A challenge in assessing the investment is that the assets of the fund are used by Skyring Capital, a related party, to lend.

Further, in section 4.2 of the Skyring Product Disclosure Statement (PDS) around the ASIC benchmark ‘disclosures of related party’, it is disclosed that benchmark of not lending to related parties is not met. This is highlighted in the PDS with the statement that ‘Skyring may make loans to our related parties….’.

While the statement later emphasises that these loans are made on the same commercial basis as other loans, the question for investors will be whether lending criteria are as rigorous for related parties as they are for arm’s length borrowers.

The challenge of liquidity and an uncertain return

Skyring is clear that investors cannot expect quick access to their money, and that the quoted 5.85 per cent is just an ‘estimate’ that ‘may change’.

There is also a clear statement that ‘the Fund is a non-liquid managed investment scheme which means investors will not be able to withdraw their investment in the Fund unless we make a Withdrawal Offer.’.

They do say that they intend to make withdrawal offers each quarter, although this is not guaranteed and, where there is a withdrawal offer, there is no guarantee that investors will get the full withdrawal requested.

Conclusion

It is a challenging time for investors, particularly those who rely on portfolio income.

One of the temptations is to look at the increasing number of ‘high yield’ investment opportunities. However, it is important to think about the core qualities of traditional cash and fixed interest investments, including credit quality, liquidity and lack of volatility.

While an investment in a fund offering higher income payments like the Skyring Fixed Income Fund may have a role somewhere in the higher risk assets in a portfolio, it has characteristics significantly different from a traditional fixed interest or cash investment.