Retirees face some tough choices when investing in low interest rate environments. Self-funded retirees use their savings to fund their living expenses and therefore cannot afford to invest a great deal in riskier assets. There is the risk that they lose capital and then do not have the time horizon to sit and wait for the investments to recover. Hence retirees are looking for investments which generate income but offer lower levels of risk.
Buying Bank Shares
Banks shares are traditionally thought of as popular when interest rates are high. It is rational to think that high interest rate means higher net margins for banks and higher profits. Higher bond yields boost bank profits as there is a link between loan rates and the 10-year treasury rate. Banks make money from the difference with what they earn by funding longer term assets with what they pay for shorter term liabilities.
However, when interest rates started falling in 2012, investors started turning to bank stocks to get a better yield.
Australian bank shares pay dividends within the yield range of 6%. With franking on top, the real return is greater than 8.5%. This allows a self-funded retiree to receive stream of income in the form of dividends. This return is much higher than the interest rates they would receive for depositing their savings in a bank account which is about 2%.
Having said that, when interest rates eventually rise, the yield of the banks compared to the cash rate starts to narrow and the attractiveness therefore starts to diminish
Holding bonds for the long term have not been an effective strategy when there are other asset classes generating higher interest rates. Bonds have been popular when equity markets are in panic mode so it makes more sense to sell bonds when fear is pervading the equity market rather than holding them long term. Bond prices start to trend higher when demand is increased.
Buy Preferred shares/Hybrid Securities
These shares have higher yields than bonds but characteristics of bonds such as interest rate sensitivity and regular payments. Hybrids have yields around 7 – 8 per cent. Hybrids are a way for companies and banks to borrow money so they act like a bond where investors are paid interest payments. They are risker than bonds as interest payments may be affected by the earnings of the company. Hybrids are also less liquid than shares so in the event an investor wants to exit their hybrids quickly, they may have to do this at a lower price. These instruments also have an option of converting into shares.
Invest in Corporate Bonds
The Australian 10-year bond yield is only 2.46% and has been low for some time. Investors relying on income from their investments should think about investing in corporate bonds. There are unrated corporate issues which have yields of four to six per cent above the government bond yields. There are also investment corporate bond funds which are yielding between 5.3 and 8.5 per cent.
Lauren Hua is a private client adviser at Fairmont Equities.
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