Safe haven may come with hidden risks

Got a yearning for yield? You're not alone. Income has become the holy grail for many investors trying to cope with the continuing outfall from the global financial crisis.

Got a yearning for yield? You're not alone. Income has become the holy grail for many investors trying to cope with the continuing outfall from the global financial crisis.

It's not hard to see why. Income is money in your hand. It won't disappear in the next market dip like capital gains. Income can be guaranteed, as with term deposits and other fixed-interest investments. You know how much income you'll get from the outset - a trait that's particularly attractive for retirees who can then budget for their living expenses. Some income investments even guarantee your capital, so long as you're prepared to wait until the investment matures to get your money back.

In uncertain times, income-based investments can provide much-needed certainty in your investment portfolio. But no investment is completely without risk. And, ironically, as income-based investments grow ever more popular, those risks are increasing.

The Australian Securities and Investments Commission has sounded another warning about the deluge of hybrid securities coming onto the market. Hybrids have been sold heavily to yield-hungry investors. Whether they're structured as subordinated notes or preference shares, hybrid securities are sold as a high-yielding alternative to investments such as term deposits. But as the regulator is keen to stress, these securities are a totally different creature and investors chasing the attractive yields on offer need to weigh them carefully against the extra risks.

For starters, these securities are generally subordinated debt, which means they are a long way down the queue if the company goes belly up.

For many investors buying hybrids from household names, this doesn't seem like a big issue, but common sense demands you should seek a reward for taking on this extra risk. More importantly, the terms of most hybrids allow the company to suspend the "interest" payment on your investment if its financial position deteriorates. Each security is different but it is critical to understand how and when your income could be stopped and when, if ever, you're likely to recoup those missed payments.

As the recent Crown Casino notes issue highlighted, hybrid investors could also be locking their money up for much longer than they may have anticipated. Crown's notes don't mature until 2072. Yes, that's 60 years away. As ASIC points out, a 40-year-old investing today would need to live to 100 to see their investment mature, if it runs the full term. While there are generally provisions for hybrids to be redeemed much earlier, this is at the issuer's discretion. In the worst case, you could find yourself locked in for the full term. Of course, most hybrids are listed on the stock exchange, so you can sell if you want to get out early, but there is no guarantee you will get your full investment back. Hybrids can, and have, traded well below their issue price. While they might offer an attractive yield, hybrids do not offer the security of investments such as term deposits and investors need to ensure they are being rewarded for the extra risk. Not that term deposits are entirely without risk either.

I am hearing more stories of retirees looking to roll over term deposits and finding rates have fallen and they'll have to take a cut to their income. To a large extent, depositors have been cushioned from falling interest rates by stiff competition for retail deposits but rates are still coming down.

According to the Reserve Bank, the average three-year term deposit rate has fallen from 7 per cent in early-2010 to 4.85 per cent in July.

The average rate across all term deposits has fallen to 3.75 per cent but if you shop around for a special you can get almost a percentage point more. In hip-pocket terms, a retiree who put $100,000 into an average bank three-year term deposit in late-2009 would have their income cut by almost a third if they automatically roll over their deposit when it matures.

Bonds are touted as a solution to this problem because they can be traded and, as interest rates fall, the value of the bond increases.

However, the global flight

to safety has seen yields on Australian bonds halve in the past 18 months, raising questions of just how long the glory days for bonds can continue.

The head of investment market research at Perpetual Investments', Matthew Sherwood, says global investors have quadrupled their exposure to federal government bonds since the global financial crisis and now hold 85 per cent of outstanding government bonds, compared with just 33 per cent 10 years ago. He says the last time real yields were about 3 per cent (in the early-1950s), real returns for the next five years were minus 1.6 per cent a year, with capital losses outstripping income.

While markets remain cautious, bond prices may well hold up. But when interest rates start to rise again, bond prices will come under pressure. In the sharemarket, income-producing stocks such as the banks and Telstra have led much of the recent recovery, leading some analysts to talk of "expensive defensives". Their argument is the focus on yield has led to these stocks becoming comparatively expensive in relation to the broader market and investors could be paying too much for their safe havens.

With many of these stocks still trading on prospective price earnings ratios of 11 per cent or 12 per cent and offering fully franked dividend yields of 6 per cent or 7 per cent, prices don't appear overly expensive. But as we saw in the global financial crisis, if earnings of these companies fall, dividends can be cut and share prices can fall. Even if you are investing for income, there are still risks to be considered.

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