Lower cash rates and government bond yields have prompted a widespread hunt for income-producing investments. Although interest rates are likely to head up when the economy shows sustained signs of improvement, the yield climate will probably remain challenging. As a consequence, demand for investments such as dividend paying stocks and investment-grade corporate bonds is likely to remain high.
For an investor entering retirement, holding a well-diversified, actively managed portfolio will be key. Growth and defensive assets both play an important part of the asset mix to meet the longer-term needs of retirees. However, a portfolio’s allocation to equities or bonds will largely depend on what age the investor plans to retire and how much capital they’ve accumulated.
Income with a focus on preserving wealth
Bonds aim to preserve capital, making them the ideal place for people who don’t want to suffer losses, such as those approaching retirement.
Looking over the past 10 years, the worst year for investment-grade bonds was 2008 when they lost 5.1%. Compare this with global equities, which fell around 40% that same year.
As well as their defensive characteristics, we believe corporate bonds are currently offering superior yield for risk. A typical diversified corporate bond fund currently offers a yield of around 4.5% per annum (as measured by the AMP Capital Corporate Bond Fund in March 2014).The Australian 3 year government bond is yielding 2.83% (as at March 2014).
Although many corporate issuers have healthy balance sheets, they’re not being rewarded for this. The excess yield offered by corporate bonds over government bonds has subsequently remained high.
Watch out for the red flags
While there is a strong case for investments offering a decent yield, it needs to be acknowledged that this can come with its pitfalls. The dangers of seeking yield in today’s low yield environment have just as much potential to derail retirement as the dangers of seeking high levels of capital growth.
For corporate bonds, higher yields mean more credit and liquidity risks. Therefore, to lessen the risk of capital loss, investors should take the time to really understand the securities they’re buying. Some of the red flags to look out for include companies that have made major capital outlays and large acquisitions. Also, any changes in the corporate strategy of the issuer can signal a change in credit risk. For example, companies that are deleveraging are generally attractive fixed income investments, while those that are releveraging should be avoided.
Jeff Brunton joined AMP Capital in January 2008 as Head of Credit Markets. Jeff is responsible for overseeing the credit investment process as well as conducting stock, industry and macro research in credit markets. Jeff is chair of the Credit Investment Committee and is also a member of the Infrastructure Investment Committee.
