The Ten Commandments of Income Investing

Economic uncertainty means there's no better time for investors to have a portion of their portfolios allocated to fixed income.

PORTFOLIO POINT: Though interest rates are expected to fall, investors should always have a portion of their portfolios allocated to fixed income products. And with uncertainty still high in the economy, there’s no better time than now.

I learned something interesting from Google today: searches for the word "uncertainty" have almost doubled since the beginning of the year, despite the fact that media mentions of the term have declined considerably over that time. I cannot be certain as to why anyone would actually Google uncertainty – it’s something that former US Defense Secretary and erstwhile koanist Donald Rumsfeld might call an "unknown unknown" – but I do know that investors are suffering for it all the same.

VIX April futures have edged up 10% in two weeks, despite being at pre-Euro crisis levels, as worries emerge about the sustainability of the US rally. In Europe meanwhile, although Greece has received a bailout from the EU, investors are already asking whether it will end up making any difference to the beleaguered economy.

And in China, the uncertainties are legion. Even Xi Jinping, China's next mooted leader, appears to doubt his country's economic miracle: a miracle that is now bequeathing a ramp-up in inflation and some very worrying trade and manufacturing indicators. (For more on the inflation story, see my note from Monday, An Emerging Opportunity)

Add to that this week’s surprise announcement on a leadership contest from Kevin Rudd, a decision by Iran to block UN inspectors from certain nuclear facilities, which sent oil higher, plus the rise of presidential candidate Rick Santorum to lead US Republican polls (the New York Times says he once warned of an attack on America by Satan), and it’s no wonder that people are feeling skittish despite recent market strength.

In investing, there are generally two types of assets: things you buy for price appreciation (equities, investment properties) and things you buy for income (bonds, term deposits, annuities). Sometimes there are products that offer both attractions (some equities, some property, some ETFs, plus hybrids and currency if you invest the Doug Turek way), but if you want security in your securities during uncertain times, income – not growth – is your main objective.

In the current environment, I believe people should do two things: 1) diversify out of the Australian dollar, and 2) invest more in income products. For this reason I think that of our four-part series of investment commandments, today’s instalment is the most important. If you know a good tomb-maker, you should engrave these commandments in stone and put them in your front garden.

1. Thou shalt protect thy principal and thy principal shalt protect thee

Fixed income is often equated with safety, and sometimes for good reason. But it’s not. In the income investment spectrum, there’s everything from AAA-rated government-guaranteed bonds to junk-grade government-guaranteed bonds (plus a few sub-prime mortgages and Gold Coast property debentures halfway along).

With that wide scale of risk, there is a wide scale of returns: US Treasury bonds currently yield 0.6% (their inflation-linked series yields 3.06%, which is actually pretty nice if you invest from the origin of a declining cross currency like the yen or are a deflationist) and Greek 10 year bonds trade at rates over 34%. But while this explains some of the attractions of Australian government debt, which offers relatively high yields – 5.57% on the 10 year note – for relatively low risk, it also explains why you mustn’t treat fixed income as some kind of principal portion of your portfolio, but rather apply the rules of principal and interest to the asset class as you would any other.

And what I mean is just that: keep your principal separate from your interest. If you own a fixed income product that yields 7% per annum, put that 7% extra somewhere else; don’t conflate the two as the same. Further, the fixed income component of your portfolio is not the equivalent of the cash component of your portfolio, though people often lump the two together. Whatever your home currency is, this should form the safest part of your total asset base and whereas your equities allocation is a risk component of your portfolio, your fixed income holdings are a risk investment too. It’s just (hopefully) a lower-risk investment.

2. On earth there is no safe haven

Similar to the First Commandment, there are no true safe havens in fixed income investing. And just as sub-prime mortgage-backed securities had misleading AAA ratings from some credit agencies before the financial crisis, there are certainly many sovereign borrowers that either have their AAA ratings on what’s known as 'credit watch' or should have their AAA rating removed.

AAA, besides standing for the Australian Alpaca Association, simply means the issuer is assessed to have an extremely strong capacity to repay its financial commitments. It does not mean that the investment is risk-free, which of course, nothing ever is. This is an issue of great concern to institutional investors, especially as US bonds now offer virtually no yield and many mandates require fund managers to invest all the same, but it is also a concern for you. And the solution? Diversification.

3. Thou shalt not concentrate thy yield

It’s obvious that you shouldn’t invest all your money in one stock, but people often seem to invest all their fixed income portfolio in one bond, term deposit or hybrid note. If you have a fixed income portfolio exposed to a variety of products and product types '” which could include annuities, bonds, hybrids, debentures, term deposits, bank bills and certificates of deposit '” you’re safer than someone who has their income riding on one asset.

Similarly, you should consider diversification by geography and issuing currency. If you have all your fixed income coming from one currency, what will you do if that currency falls or interest rates go south? While the rest of the developed world doesn’t offer the kinds of yields that Australia does for the same level of sovereign risk, this is an issue to consider with our dollar still at record levels and more downside than upside risk expected. Perhaps those 0.6% returns don’t look so bad after all.

4. Thou shalt knoweth the law of 72

The law of 72 is thus: to work out the value of a fixed income product in terms of simple interest, divide 72 by the rate (say 6%) and you will find the number of years it will take for your capital to double (answer: 12).

This law has been around since at least 1494, when Venetian mathematician Luca Pacioli wrote the Summa de Arithmetica, and it still works well for most investors, though using the number 69.3 is more accurate for calculating continuous compounding, and modern financial calculators also use a slightly different rule. Still, there’s no need to go into the time value of money here, or theories of net present value, or exponential growth and decay: for the most part, the difference to retail investors will be no more than the value of several cups of coffee per year; a rule I remember as the summa de arabica.

5. Thou shalt not invest in contracts thou donst understand

Returning to the over-used but ever-useful example of subprime mortgage-backed securities, investors should never invest in contracts they don’t understand. It was through an appalling lack of judgement and lack of fiduciary responsibility that institutional investors bought the financial alchemy of Goldman Sachs' Abacus 2007-AC1 CDO (collateralised debt obligation) but sometimes even highly-remunerated financial wizards can be just as stupid as you or I.

As they say, ignorance is no defence and you can avoid designed-to-fail “monstrosities”, as one of Abacus’s creators described the issue, if you simply refuse to invest in what you don’t understand. And, if any salesman tells you it’s a once-in-a-lifetime opportunity or that you don’t need to read the fine print, then run a mile. (For a critique on the fine print of recent hybrid offers, click here for our Wednesday examination by Philip Bayley)

6. A high yield is too high indeed

One of the way investors can be blinded to the risks of complex fixed income securities is through a high yield. Recently at Eureka we heard about a Gold Coast scam (where else?) that offered investors interest rates of between 1% and 3% per week.

Luckily, it appeared this offer was too good to be true for all but the most credulous and the scheme only lost investors $250,000, but there are products that offer more reasonable, but nevertheless attractive, rates that are nevertheless dangerous. This at least was the trick used by Bernie Madoff to lure his investors in: by offering a return that’s unbeatable, but only a little bit unbeatable.

Generally speaking, anything that’s over 8% in yield – that is, more than you’d pay on any type of loan from an Australian bank – should be considered a high risk, or at least a signal that very careful research is needed. You will find good, high-income opportunities and Eureka Report endeavours to present these to readers regularly, but you will find just as good a long-term outcome if you take a more conservative approach. Again, if you think you don’t understand it, don’t invest.

7. Thou shalt know thy taxation (though not to the exclusion of all else)

Especially when it comes to property investing and sharemarket dividends, Australian investors become obsessed with the tax credits. But while it’s a good thing to understand the various taxation benefits of investing in shares and property for income, you shouldn’t lose sight of the wood for the trees: taxation benefits should always be a secondary concern; your primary concern is whether the investment makes sense from a risk and return basis.

And besides, if thanks to your carefully constructed and rigorously researched portfolio you’re making lots of money, then you should be glad to pay the tax.

8. Thou shalt know thy valuations

Most everyone who invests in the sharemarket understands the importance of buying low and selling high, or at least looking for and understanding value. It’s the same in the fixed income market, despite the fact that many products fluctuate relatively little in terms of capital price.

Obviously the yield, whether in the form of coupon or dividend, will determine the value, but so too will the investment’s risk-adjusted return: an issue we looked at in two recent notes: Banks: Duck and cover, and Time to review CBA Perls. If you’re getting a dividend of about 6% from a stock you own, great. But if that stock’s price has potential to fall, then adjusted for risk it's probably well below the true value of owning a 90 day fixed term deposit at a 5.5% rate.

9. A dividend without earnings is like a house built on sand

Speaking of downside risk, a classic warning sign for income investors in the sharemarket is when a stock’s dividend per share is larger than its earnings per share; ie, when the company has to effectively borrow money to bribe investors to hold.

Obviously, this can happen to some of the best companies from time to time, especially if for unusual reasons they report a half-year or annual loss but don’t want to ditch the dividend policy. But as a general rule, avoid these scenarios and chances are you’ll avoid a falling share price as well.

The simple rule is to make sure that earnings exceed dividends by a sufficient margin and that earnings growth is on an upward trend. Not only will this provide a safety buffer, but it gives you upside potential for dividends to be raised. The alternative, meanwhile, is to end up with a high-yield disaster like many of the A-REITS were during the financial crisis.

10. Thou shalt be patient and maintain thy faith

Income investing is about patience, not about making money quickly. Low returns should be accepted for low risk if safety is what you seek and indeed, safety is what you should seek from a fixed-income portfolio if it’s to be balanced with higher-risk investments in property, shares, currency, fine wines or Aboriginal art.

As we’ve banged on about many times in Eureka Report, investing is a long-term game and especially when seen through the context of retirement and superannuation – a concern of most readers – the virtues of prudence and patience are greater than the virtues of courage and risk. Occasionally there’ll be stories of junk-bond kings, or investors who made quick returns in distressed debt, but those investors are typically highly skilled professionals with backgrounds in quantitative risk analysis and huge portfolios of diversified exposures.

When it comes to fixed income, leave the mad money behind.

This is the final in our four-part series. If you missed any of the previous commandments, see The Ten Commandments of Property Investing, Buy and hold’s Ten Commandments and The Ten Commandments of Trading.

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