As interest rates paid on term deposits come tumbling down, those looking to earn decent income with minimal risk to their capital are scratching their heads.
Only two years ago, investors could earn 6 per cent, compared with just less than 4.5 per cent now. And the first $250,000 an investor has in term deposits with a bank, credit union or building society is guaranteed by the federal government. But if the Reserve Bank cuts the cash rate even more, as expected, then term-deposit rates will also fall. To do better than term deposits, investors are going to have to take some risk with their capital.
But by carefully selecting investments and diversifying, perhaps via a managed investment, they can cut the risks substantially.
Cash at call
The port of call for those who want absolutely no risk to their capital, but with a higher interest rate than term deposits, is an online saver account. Interest earned on such accounts can be at least half a percentage point above the 4.5 per cent earned on term deposits.
The accounts are also covered by the government guarantee, and the money is available at call. But to earn the higher interest, investors have to meet some conditions and the marketing tricks can be pretty slick. Online savers typically pay a bonus interest rate on top of the base rate. But the bonus rates usually apply for only the first four or six months. After that, the interest rate reverts to the base rate, which is usually more than 3 per cent but can be zero. Conditions to earn the bonus rate can include that a minimum amount is deposited each month, or withdrawals are limited to a certain number. Some have fees, such as for account keeping.
To earn even higher rates of interest - more than 5.5 per cent, say - higher-quality corporate bonds can be a good way to go. Investing in a corporate bond means lending money to a business that makes interest payments in return. At the end of the term, all the capital is repaid. The risk with a corporate bond is that the company gets into trouble and might not be able to pay all the interest, or return all the capital at the end of the term.
Corporate bondholders stand before shareholders in the queue to get repaid if the company fails. Usually, the higher the credit-worthiness of the company, as determined by its credit rating, the less the company has to pay on its bonds to attract investors. A problem with buying bonds direct is that big investment amounts are usually needed. Fixed-interest brokers can generally sell corporate bonds to investors who are prepared to invest a minimum of $50,000 a bond.
Unlisted managed funds, in which the fund manager holds a portfolio of Australian government and corporate bonds and perhaps some global corporate bonds, can be a good way for small investors to get instant diversification for a small amount of money. Most funds require an initial investment of only a few hundred dollars, and have regular savings plans in which money can be deposited into the fund automatically. As the interest rate on 10-year Australian government bonds is only about 3.5 per cent, bond funds will need exposure to higher-paying corporate bonds to achieve returns that are better than term deposits. Lower credit quality bonds can pay more than 7 per cent, and a bond fund is likely to have limited exposure to these to help boost returns.
Exchange-traded funds (ETFs) are being listed on the Australian sharemarket almost every week. Most ETFs are index trackers, meaning their return matches the market returns they are mirroring. ETFs cover all sorts of markets such as the gold price, the biggest 200-listed shares on the Australian sharemarket, and specific sharemarket sectors such as resources.
There are at least half-a-dozen ETFs that track higher-yielding Australian shares, including a couple that track the higher-yielding financial services sector dominated by the big banks. ETFs are traded like any shares, and management fees are generally lower than for managed funds.
Equity income funds
Income share funds have made a return as fund managers seek to satisfy the demand by investors for income. These are managed funds that invest in higher-yielding Australian shares. The funds have done well because the "grossed-up" yield (after the benefit of imputation credits) on the Australian sharemarket in the past year has been almost 6.5 per cent. The research manager at Morningstar, Tom Whitelaw, says income investors have to be comfortable with the fact that though the funds are investing in higher-yielding shares, they are still investing in the sharemarket, with its associated risks.
Investors could bypass the fund managers and their fees and buy the shares of the big banks and Telstra themselves. That is what many income-seeking investors have been doing, and it is the reason the share prices of most of the big banks and Telstra have risen strongly in the past year.
Real estate trusts
The chief economist at AMP Capital Investors, Shane Oliver, says Australian Real Estate Trusts (A-REITs) are worth considering. These are trusts listed on the Australian sharemarket that invest in a spread of retail, commercial and industrial property, or specialise in one of these sectors. Before the global financial crisis, they were regarded as one of the main alternatives to investing in cash.
"Of course, it all fell apart when the GFC exposed the reality that the sector had become highly geared and focused on non-property-related activities," Oliver says. But the sector has come back with a yield of about 5.5 per cent, he adds. And investors in the sector have enjoyed very strong capital gains over the past year.
"Gearing levels have fallen and the sector has gone back to its knitting, so to speak," Oliver says. Investors could look at some of the bigger listed A-REITs, or a property securities fund that invests in A-REITs. The risk-versus-return trade-off is about the same as for income share funds, Oliver says.
The research manager at Morningstar, Tom Whitelaw, says a new breed of "enhanced" income equity funds boost income by using derivative overlay strategies to supplement the dividend income paid by the shares in which the fund invests.
These are different from the traditional income shares funds that hold only the better-yielding Australian shares without using derivatives. The most common derivative used by the enhanced equity income funds is called "buy-write".
Put simply, it means the investor in the fund is giving up or capping some future capital growth for more income now.
Whitelaw says that in rapidly rising markets, the returns of the these funds are likely to lag market returns. They should do better than the markets in which returns are falling, flat or slowly rising, he says.