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A friend asked me during the week where he could “park” some cash while he was tossing up possible renovation plans for his home.  A similar situation might be faced by those saving for a home deposit or who already have a deposit and are waiting for home prices to fall before jumping in to buy.

The first suggestion that comes to mind would be to focus on removing volatility from any possible investment (and in doing so reducing risk).  In particular, a serious look at investing for income is definitely warranted.  So what is investing for income?

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The most commonly understood way to earn income from an investment is through cash and fixed interest style investments.  The common thread between these investments is that they pay regular interest payments over time while the initial value of the investment does not grow.

At the moment these style of investments are offering relatively strong returns.  The Weekend Australian Financial Review provided a good summary of some of the better returning cash and fixed interest style investments.  They firstly looked at cash accounts with the most compelling options those provided by online saving accounts.  The top three were Bankwest 8.25%, RaboPlus 8.00%, ING Direct 8.00% (It should be noted that these are introductory offers but still great returns.)

The great benefit of cash is that it is easily converted into money that can be used to purchase goods and services.  In financial terms these investments are highly liquid.  You are also very confident that you will not lose any of the initial investment along the way.  The major risk is that while this money is sitting in cash, alternative investments are providing a higher rate of return.

The next in the pure income line of investments are term deposits.  For agreeing to lock your money up with a financial institution for a given term, the institution pays you a slightly higher return compared to deposit accounts.  It was interesting to note in the AFR article that not until terms of at least 90 days were the rates above or equal to the rates offered by the top online savings accounts.  Basically what the current rates are telling us is that an investor is not compensated for having money locked away for less than a 3 month term.  The major risks with this type of investment is that you either need the money before the end of the term or interest rates in the economy increase meaning that your money could be yielding higher levels of income elsewhere (for the same level of risk).

The third basic category is fixed interest securities otherwise known as government or corporate bonds.  Investors purchase these investments with the issuer promising to pay a particular rate of return over a given term with the initial investment being returned to the investor at the completion of the term.  Bonds are traded and therefore once issued may move up or down in price. These changes are most likely caused by changes of interest rates in the economy or a change in the likelihood of the issuer meeting its repayments on the bond.  The major risks therefore are that interest rates in the economy increase causing the price of the bond to fall in value also meaning you could get better returns elsewhere or the issuer is unable to make the payments as required.  (More about this default risk later).

From here we move to less traditional cash and fixed interest securities.

In between the pure fixed interest investments and growth assets, like shares and listed property, are what are known as hybrids.  These are bond-like offerings which provide regular income payments but have equity characteristics. Should a company collapse, holders of these securities are treated like shareholders and their claims come after the claims of debt holders (bond holders).  You therefore should expect to be paid higher rates of income compared to bond holders.  For more information on an example of this style of security take a look at Scott Francis’ recent Eureka Report article – Suncorp offering with a bonus.

The clear risks with hybrids are that the company will not be able to make the payments however one risk that is removed is that of interest rate movements.  The products tend to have a floating rate tied to a relevant cash rate.  At the moment the premium above the cash rate is high as the credit market is tight and companies have to pay more to secure your money.

Then we come to the property sector.  Most people invest in property to hopefully see the value of the property grow.  However, there is also the benefit of receiving rent provided by tenants.  We access property exposure in our portfolios through listed property trusts.  Latest figures put income from listed property at 8 or 9%.  However, it should be noted that there has also been a significant depreciation in the value of listed property trusts over the past year, the worst year in history.  Therefore the major risk of utilising property investments for income is that the price of the investment will fall in value.

Finally, the last major income producing investments are shares.  Again, many investors get caught up in the growth side of the share return story while forgetting the income being provided through dividends paid by companies.  This story is particularly attractive in the Australian context thanks to the dividend imputation tax system whereby companies are able to pass on dividends that effectively have already been taxed at 30% before reaching the investor.

The AFR article on the weekend provided some interesting figures regarding dividend yields.  Historically companies in Australia have paid yields for industrial stocks averaging 5.2% since 1961.  Goldman Sachs JB Were are predicting yields of 5.9% for the year up from 5.6% last year.  Macquarie Research forecast 6.1% for the current year increasing to 6.4% in the following.  This gradual increase in dividends being received by investors is a real benefit of these investments that is often forgotten.  Of course the recent plunge in sharemarkets have detracted from shares as investments but if you are willing to hang on and wait for share prices to rise, this level of income being paid is nothing to be sneezed at especially given the tax benefits of fully franked dividends.

Across all of the income producing investments there is an underlying risk that the holder of your cash, including shares, will not be able to return it when required.  i.e. they default on returning the money you have loaned them.  The greater the risk of this occurring, the higher the return that should be expected by investors.  Groups like Standard & Poors help determine this risk by providing ratings of the underlying products and companies.  Having consideration of the rating of a product or company is key to assessing whether the investment is suitable for you.  It is interesting to note that the best yielding income investment mentioned in the AFR article was the Babcock & Brown Infrastructure EPS (BEPPA) returning 23%.  The recent news surrounding Babcock & Brown show that this is indeed a riskier style of investment.

For more information on this topic, Vanguard have produced a really clear explanation of Investing for Income in their Plain Talk library which is well worth a look.

Regards,Scott Keefer

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