Taking a defensive yield tack

PORTFOLIO POINT: Fixed interest securities can still deliver decent yields, even in an environment of falling interest rates. The trick is to get the right mix.

Twelve months ago, the official cash rate (OCR) set by the Reserve Bank of Australia was at 4.50%, and deposit holders could still achieve rates of around 6% for their term deposits.

Fast forward to today, investors are faced with the OCR at 3.25% and an expectation of further cuts, which leaves cash and term deposit rates at levels where most are questioning the value of their investment.

The defensive component of the portfolio has a critical role to play in not only being ‘defensive’ in capital preservation, but also ensuring a sufficient income stream can be generated.

Fixed interest re-cap

Broadly speaking, there are three options available to keep your defensive section of the portfolio ‘defensive’:

• Cash
• Lending to governments
• Lending to high-quality investment grade borrowers

The more you move away from these three options, the more you potentially lose the true benefits of defensive investments. Notwithstanding, one still expects to receive a rate of return in this sector, albeit at a lower rate to compensate for the lower level of risk taken on board.

So what options are available to combat the reduced income levels of cash and term deposits in the fixed interest sector?

Hybrid securities

A debt instrument that is ‘considered’ to be in the defensive section of the portfolio are hybrid securities. These securities are higher yielding in nature, generally paying a margin above the bank bill swap rate. When buying a hybrid security you are typically lending money to a bank, insurance company or large corporation, known as the issuer. In return for the loan, the issuer pays a given interest rate (called the coupon) for the life of the security, repaying the principal at maturity. As the name suggests, hybrid securities are a mix of between a debt and equity instrument. Given the nature of the mix of both debt and equity characteristics, it’s important to note that these type of instruments have significant volatility and thus capital risk and may not suit risk averse investors. The real risk associated with a hybrid security is related to the issuer not meeting its obligations of paying you the regular income stream as specified, or the issuer plainly defaulting. While many would consider this risk not to be that high, let me cast your mind back to hybrid issues from Elders (ELD) and PaperlinX (PPX), where these companies stopped paying their income distributions. This reinforces the need to evaluate not only the terms of the debt issue, but also the issuer itself. However, for those with an appetite for such securities, strong income levels can be generated. The rate of return currently ranges from approximately 6% for a Mandatory Convertible Note to 7%-8% for a Subordinated Note offered by a corporate such as Origin Energy or Caltex Ltd. These are compelling returns in the current climate.

Appoint a fixed interest specialist

The fixed interest world is significantly larger and more complex than the simplistic view of giving your money to the bank, and them reciprocating with a rate of return and the promise of returning your capital upon maturity. Delegating the responsibility to a fixed interest specialist, a unitholder can benefit from holding government bonds, semi government bonds and corporates which assists with the diversification process, but also the opportunity to improve the rate of return relative to cash and term deposits. A highly credible investment in this space is the Perpetual Wholesale Diversified Income Fund where the major focus is on providing regular income and consistency of return by investing in a diverse range of income-generating assets. Perpetual’s portfolio is largely made up of senior debt securities which rank the highest in the instance of a credit default, therefore indicating these type of securities are of a high quality. The other component of the portfolio is where the manager adds value by investing in Subordinated Debt and Hybrid debt. Honing in further on this investment, one of the key indicators beside the make-up of the grades of investment is also the current running yield of 5.70% which is highly competitive in the current market. Distributions are paid to unitholders on a quarterly basis, assisting clients’ cash flow requirements combined with a running yield of 5.70% reinforces the need to look outside the traditional cash and term deposits in search of replacing lost income from the portfolio. Importantly, fixed interest tends to have lower volatility than hybrid securities.

Where do dividends from my Australian share exposure fit in?

A common approach is to overweight exposure to Australian shares in order to gain dividend yield. While this approach in a simplistic view is sound, by taking the dividend yield approach, the portfolio’s overall inherent risk increases significantly. As we have seen through the GFC, and now through this extended period of uncertainty, investors’ portfolio volatility has increased, and has certainly made investors, such as retirees who rely on their portfolio, move around to uncomfortable levels. So is it wise to increase your Australian share exposure at this time to increase your portfolio’s income producing power? The short answer is No. Your allocation to equities should be considered in the ‘growth’ sector of the portfolio, and the structure of the investments within this sector should be viewed separately to that of your defensive component of the portfolio. While at the end of the day the income from the equities you hold ultimately flows through to your bank account, blurring the roles of the growth assets and defensive assets is fraught with danger.

What is the ideal mix?

While cash and term deposit rates are falling, it is still important to have an allocation to these investments in your defensive component of the portfolio. It is also important to have an allocation to an active fixed interest manager(s) and hybrid securities for those with the risk tolerance to complement the plain vanilla cash and TDs. What will assist you in generating a respectable income return from your portfolio will be the composition between these assets and the appropriate exposures.

This article is the latest in our series The Yield Chase. To read other articles in this series, click on the story links below.

Fixing for a high yield fix

Cashing in on term deposits

Shopping for yield in Woolies’ property float

Telstra’s high-speed yield connection

Trustees seek yield safety

Yield spotlight shines on REITs

Hunting in US property

Michael Dwyer is a senior advisor with Lachlan Partners, who is the publisher of "The Investing Times" newsletter, from which this article has been republished.