The global financial crisis forced central banks around the world to dramatically lower interest rates initially to try and avoid economic depression and subsequently as a way to stimulate economic growth.
Today short-term interest rates are sitting at historic lows, including Australia, with the current Reserve Bank of Australia (RBA) cash rate at 2.5 per cent.
With this lower interest rate environment, bond interest payments and interest from term deposits which may have been serving investors income needs over the past few years are lower than historical averages.
I've looked at where current yields are on a portfolio with a 50:50 split between equities and fixed interest to demonstrate how yields have fallen for investors.
When you look back over the last 15 years, the overall yield on a domestic portfolio has averaged 4.9 per cent, however as the chart below shows, is currently sitting at 4.1 per cent. Yield on a 50:50 international portfolio is currently sitting at 2.3 per cent versus a 15 year average of 2.9 per cent.
Historical yield on a 50:50 equity/bond portfolio
With this lower interest rate environment, bond interest payments and interest from term deposits which may have been serving investors income needs over the past few years are lower than historical averages.
I've looked at where current yields are on a portfolio with a 50:50 split between equities and fixed interest to demonstrate how yields have fallen for investors.
When you look back over the last 15 years, the overall yield on a domestic portfolio has averaged 4.9 per cent, however as the chart below shows, is currently sitting at 4.1 per cent. Yield on a 50:50 international portfolio is currently sitting at 2.3 per cent versus a 15 year average of 2.9 per cent.
Historical yield on a 50:50 equity/bond portfolio
So investors who have become accustomed to living off the interest component of their investment portfolio are facing different challenges because they are not receiving the same levels of yield. These investors may be seeing the only choices available to them as being either accepting a lower standard of living (which most would reject) or changing their investment asset allocations.
However, this has had the effect of some income oriented investors breaking away from their normally risk-averse nature by switching out of their high quality fixed income or broad share portfolios into more risky bond exposures or more concentrated high yield share portfolios to fulfill the income objective.
But these alternative exposures can increase the risk profile of the portfolio and decrease diversification which over the long term may leave the investor more exposed to volatility and market risk.
Consider a strategy of switching into high yield shares – a common road taken by a lot of Australian investors.
First up, and it may sound obvious, high yielding shares are not a substitute for fixed income term deposits. They do not provide the same low correlation to shares that term deposits do and so shifting the defensive portion of your portfolio from fixed income into high yielding shares effectively will remove the buffer you have to swings in the share market. Regardless of yields, term deposits have a role to play in every investor’s portfolio and should be held for their long term diversification benefits.
Given the significant interest in high yield shares, valuations relative to the broader market have increased by 11 percentage points since 2010 (to 84 per cent versus a 15 year historical average of 73 per cent), indicating this segment of the market may be overvalued.
Historical price/earning ratios
However, this has had the effect of some income oriented investors breaking away from their normally risk-averse nature by switching out of their high quality fixed income or broad share portfolios into more risky bond exposures or more concentrated high yield share portfolios to fulfill the income objective.
But these alternative exposures can increase the risk profile of the portfolio and decrease diversification which over the long term may leave the investor more exposed to volatility and market risk.
Consider a strategy of switching into high yield shares – a common road taken by a lot of Australian investors.
First up, and it may sound obvious, high yielding shares are not a substitute for fixed income term deposits. They do not provide the same low correlation to shares that term deposits do and so shifting the defensive portion of your portfolio from fixed income into high yielding shares effectively will remove the buffer you have to swings in the share market. Regardless of yields, term deposits have a role to play in every investor’s portfolio and should be held for their long term diversification benefits.
Given the significant interest in high yield shares, valuations relative to the broader market have increased by 11 percentage points since 2010 (to 84 per cent versus a 15 year historical average of 73 per cent), indicating this segment of the market may be overvalued.
Historical price/earning ratios
A last word of caution to consider when investing in high yield shares is the potential sector concentration risk you may be building into the portfolio. High yield shares can often be highly concentrated in financials and utilities, which results in less diversification and potentially greater risk relative to the broad market.
So how should investors respond to reduced yield and an absence of adequate income in their portfolio?
Because we believe that an income only strategy can be damaging to the overall health of a portfolio, at Direct Advisers we are strong proponents of the concept of total return investing – or investing for cash flow and capital appreciation.
Our research shows this to be a superior approach in particular for those in the drawdown phase of their investment lifecycle.
This approach advocates keeping your portfolio broadly diversified and focused on the overall, or total, return. Where the need for additional income occurs over and above the yield generated by this broadly diversified portfolio, the investor spends the amount made from the overall portfolio - or the total return - rather than switching around holdings to generate additional yield.
There are two key advantages to taking this approach.
The first is that you will maintain your portfolios risk profile through maintenance of diversification rather than, for example, deciding to invest in a narrower, concentrated fund or collection of shares. You allow your portfolio to be more tax efficient which may be something that suffers if you are following an income only approach through purchasing taxable bond funds or income oriented shares.
So how should investors respond to reduced yield and an absence of adequate income in their portfolio?
Because we believe that an income only strategy can be damaging to the overall health of a portfolio, at Direct Advisers we are strong proponents of the concept of total return investing – or investing for cash flow and capital appreciation.
Our research shows this to be a superior approach in particular for those in the drawdown phase of their investment lifecycle.
This approach advocates keeping your portfolio broadly diversified and focused on the overall, or total, return. Where the need for additional income occurs over and above the yield generated by this broadly diversified portfolio, the investor spends the amount made from the overall portfolio - or the total return - rather than switching around holdings to generate additional yield.
There are two key advantages to taking this approach.
The first is that you will maintain your portfolios risk profile through maintenance of diversification rather than, for example, deciding to invest in a narrower, concentrated fund or collection of shares. You allow your portfolio to be more tax efficient which may be something that suffers if you are following an income only approach through purchasing taxable bond funds or income oriented shares.
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