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How to find real income

Christine St Anne
Thursday, May 05, 2016

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By Christine St Anne

Switzer Daily brought together portfolio managers from bond managers PIMCO and Kapstream to talk about fixed income investing. 

They were joined by facilitator Peter Switzer to explore the themes, challenges and opportunities to investing in fixed income. In the fourth part of the series we look how to secure in a low-return market. 

Bond managers expect interest rates to remain lower for longer as highlighted in the previous article, investing in a low-growth world

The Reserve Bank of Australia is even expected to cut rates further follwoing this week's decision.

Amid an environment of anaemic growth and low rates, roundtable facilitator Peter Switzer asked how can investors find real income? 

Kapstream’s Kumar Palghat says the income challenge will force investors to rethink the way they manage money and the way the approach bonds. 

As bond managers, it was tricky to compete against the 5 to 7% term deposit rates pre-GFC, however, bonds offer liquidity and greater diversification than term deposits, according to Palghat. 

“Everybody needs some form of liquidity. With term deposits you are locked into a term and exposed to a single institution. With bonds, you are getting paid better than term deposits but also have that liquidity and diversification across a number of institutions,” Palghat says. 

PIMCO’s Rob Mead says bonds bring a lot of benefits to an overall portfolio. It’s not just about the return but also managing risk. 

“When thinking about retirement, people should think about how much volatility there are prepared to accept for a certain level of income. A stock might trade at an apparent 6% dividend yield, but its capital value could fall by 30% to 40%, in-line with some recent market experiences. Not all investors are comfortable with that level of volatility,” Mead says.

For Kapstream’s Palghat, investors tend to assume that income doesn’t come with default risk. 

When it comes to investing in bonds, Palghat says investors need to think about who they are lending money to and what risks they are getting from a certain level of return. 

As bond managers, however, Kapstream and PIMCO invest across a range of bonds including government, semi-government and corporate bonds. This ensures diversification and mitigates the risk of default. 

Palghat says the search for income will spur investors to also re-think their risk tolerance. 

“You have to take some risks if you want a rate of 4% compared to 2%. This means investors may need to consider leverage or taking on additional credit risks,” Palghat says. 

Mead says the good news for Australian investors is that they can still access a relatively risk free rate of 2.0% in term deposits, which is the starting point, or hurdle, for other asset classes to be considered for investment. However, like Palghat, Mead says investors can boost their return by taking on additional credit risk, especially global credit.

This of course does not mean investors need to consider Greek bonds. High quality global credit (fully hedged) can give investors a 5 to 6% return.

Another option are corporate bonds. These bonds offer a higher yield than a government bond given their slightly riskier profile but as Mead notes, the best companies in the world can issue these bonds.

“You have to take a risk, but in a measured way. Considering that the rest of an investor’s portfolio may be invested in things like bank stocks because of their potential dividends, then other assets, like bonds, should be considered as an income-generating diversifier in the portfolio,” Mead says. 

Published: Thursday, May 05, 2016


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