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Generating income in a low-rate environment

Money Tips

With cash rates at near zero, term deposits at historical lows and short-term government bonds at a little above zero, many investors are questioning where to get a reasonable income return without taking too much risk.

There are some good alternatives, however investors have to accept that moving away from government- or bank-guaranteed deposits and bonds involves moving up the risk curve a little with generally no guarantees.

One place to start is to look at alternative fixed interest securities.

Over the past 20 years, the major banks have been issuing a variety of securities, which are usually referred to as hybrid securities.

The securities might be called capital notes, unsecured notes or converting preference shares.

These securities are listed on the ASX so are generally liquid. They are usually issued at $100 per security and will have a term to reset of three, four or five years.

The history has been that, at the reset date, they repay the $100, or there may be an offer to invest in a new security or they could convert into shares.

There are many of these securities now listed on the ASX and all have varying terms.

From an income perspective, they pay interest or dividends at the cash rate plus a floating margin. Right now, these bank-issued securities can be purchased with a yield to reset of 3 per cent to 4 per cent per annum, so presenting a significant margin above cash and deposits.

Another place to look is at managed funds that invest in government bonds, corporate bonds and other credit securities.

Given that bond rates are historically low, investors rely on the manager’s capability to trade the bonds and securities according to market conditions to add value to your return.

The general expectation would be to achieve in the range of 2 per cent to 5 per cent per annum, depending on the level of risk in the underlying securities.

Looking further up the risk curve

Going up the risk curve a little higher, another option is to look at mortgage funds.

Commonly these are residential-first, mortgage-backed and currently generate about 4.5 per cent to 5 per cent per annum.

Higher-risk mortgage funds exist – for example, lending to developers for land subdivisions – and currently generate about 6.5 per cent to 7 per cent.

An important consideration here is to only invest with reputable managers with good track records and strong lending practises.

Another consideration is that they are often illiquid and may be fixed-term investments for up to 12 months.

Property funds, both unlisted and listed on the ASX, are another option that can provide attractive income generation.

Many of these funds generate income in the 5 per cent to 6 per cent per annum range, however it depends on the type of property fund.

Some are specific to particular property sectors, such as retail, office or industrial, while many funds diversify across all or most property sectors.

Many of these types of funds have experienced significant volatility over 2020 and hence impacted capital values, so if you are looking at primarily income generation, a more secure and diversified property fund might be the best option.

Another consideration is Australian shares.

Currently the average forward dividend yield for the ASX200 is 4.5 per cent to 5 per cent (including franking credits), and the margin of these dividends over short-term deposits is now at historical highs.

So again, if you are looking mainly at income generation and not capital growth, then looking at companies with a history of solid dividend yields would be the best option.

These are some of the ideas that could be considered. Each has different risk levels and a range of expected income returns. To lower the risk, investors could look at a diversified basket of these securities and perhaps look at a portfolio with at least a two- to three-year timeframe.

Based on current yields and returns from the different types of investments mentioned above, it should be possible to generate a net return of 3 per cent to 4 per cent per annum, substantially over short-term deposit or cash rates.

If you’d like to discuss your investment strategy, talk to your adviser or the team here at Crystal Wealth.

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