Investors, mind the traps

Have you heard this recently? "I'm a conservative income investor and I need to earn more than the 5 per cent on offer in cash accounts and term deposits. I want a safe 7 per cent to 8 per cent, like that available in the Company X preference share offer being marketed now."

Have you heard this recently? "I'm a conservative income investor and I need to earn more than the 5 per cent on offer in cash accounts and term deposits. I want a safe 7 per cent to 8 per cent, like that available in the Company X preference share offer being marketed now."

There's a huge contradiction in this investor's statement. An opportunity has nothing to do with "need". Something is an opportunity whether you "need" one or not.

Perhaps there's no longer such a thing as a "safe 7 per cent to 8 per cent". And, anyway, why should your needs have anything to do with a critical analysis of risk?

Nevertheless, there are plenty of commentators encouraging riskier behaviour to secure higher rates from income security offers from Origin, AGL, Tabcorp, Caltex and Colonial, for example, over term deposits or cash accounts.

If they've hit your mailbox, you're being targeted as in the "need" category. For conservative investors, it's a big mistake to embrace the extra yield without knowing the risks. As Raymond DeVoe jnr warned, "more money has been lost reaching for yield than at the point of a gun".

Alluring promises

For sums less than $250,000, cash accounts and term deposits are government guaranteed. Buying subordinated corporate debt instead, or hybrids, which rank just ahead of ordinary equity in a corporate collapse is reaching for yield.

Many of these "income securities" are closer to junk bonds than cash accounts.

Ordinary equities offer the potential for high returns, with risks that we're all acquainted with volatility, the chance of bankruptcy, unknown dividend flows, management incompetence and so on. These risks are mostly visible, which is why the stockmarket doesn't much appeal to our conservative income investor.

In contrast, the hybrid market holds an alluring promise not offered by equity markets: The potential for returns higher than bank interest rates, with little visible risk over that of bank deposits. It's a finance marketers dream: The upside of stocks and the protection of a term-deposit-like security. No wonder the high headline rate attracts our conservative income investor.

It's a mirage, of course. There is no such thing as a higher return without higher risk. Here are the pitfalls:

Potential non-payment of (non-cumulative) distributions

The risk of falling interest rates and yields

Term asymmetry. The current offers from APA Group and Crown, for example, will last from 6 years to 60 years, depending on what suits the borrower, not what suits you

The potential for capital loss in the event of bankruptcy or an Australian Prudential Regulatory Authority intervention

If the issuer runs into financial strife, a potential conversion to equity at exactly the wrong time.

The more obvious equity risks have been removed but the remaining ones are terrifying.

Risk curve

Think of buying income securities, especially lower-ranking ones, as the equivalent of holding a term deposit while selling earthquake insurance on the side.

You'll collect an extra per cent or two in premiums (extra interest) each year in exchange for the possibility of having your investment annihilated if disaster strikes.

If you cannot afford any losses in your portfolio, then most hybrids probably will not suit you.

Better to favour term deposits and cash accounts, lower rates notwithstanding. A bank-issued bond (such as CommBank Retail Bonds) might make sense when pricing is favourable.

A sensible reaction to lower interest rates is to stay put in safe assets and, as an unfortunate side effect, collect less interest than you once did. If it didn't make sense to sell earthquake insurance when interest rates were higher, does it make sense to sell it now?

If you think 4 per cent to 5 per cent on term deposits is low, imagine how you'll feel if one or more of your income securities goes belly up. Further up the risk curve, though, investors are abandoning "risky" equities altogether, delivering some attractive prices in selected stocks.

On a risk/reward basis, it might make more sense for conservative investors to put, say, 20 per cent of their wealth into underpriced ordinary equities than put half their wealth on the line in "lower risk" hybrids that aren't underpriced.

Australian income investors are over-sensitive to the visible risks in equity investing while unwittingly exposing themselves to risks in income securities, all in the name of being "conservative". They should be sleeping less soundly than they are.

Gareth Brown is an analyst at Intelligent Investor, intelligent investor.com.au. This article contains general investment advice only (under AFSL 282288).

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