What are the alternatives to term deposits for risk averse investors?
Investors don't have to watch their savings go backwards as inflation and low-interest rates continue to erode returns, says Realm Investment House managing partner Andrew Papageorgiou
In this episode of Expert Insights, Papageorgiou explains why conventional fixed-income vehicles continue to disappoint and how a broader view of the available options could improve yields.
"Imagine for a moment that you've got $10 million in the bank, and you're basically taking $25,000 worth risk-free income out of it," he says. "That is below what a pensioner couple receives. So much for being a self-funded retiree."
Papageorgiou emphasises the importance of calculating real returns and recommends moving a little way up the risk curve into instruments such as asset-backed securities.
"You should be able to achieve a rate of return somewhere around 1.5% with a reasonably diverse group of high-quality credit assets," he says. "And right now, that might be the sweet spot."
Only a few years ago, 1.5% would have seemed like nothing at all. But in today's environment, it's better than the real return of minus 2.55% on offer in cash.
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How would you describe the current situation for investors who want to generate a return on cash with low levels of risk?
The environment for retirees right now is absolutely unprecedented. The other key thing to understand is that it's a global phenomenon as well.
I think in some way we can get a little bit confused and feel like it's a little bit new, but you start to realise that this is something that people all over the world have been putting up with for the better part of half a decade.
The fact of the matter is that COVID has brought this low-interest rate reality to the front of mind for Australian investors. To say it is unprecedented is an absolute understatement.
If you think anecdotally, if you think about what kind of a rate of return is available for an investor at call right now, you could have $10 million in the bank. The special term deposit rate at call right now from the RBA is at around 25 basis points.
Imagine for a moment that you've got $10 million in the bank, and you're basically taking $25,000 worth risk-free income out of it. That is below what a pensioner couple receives. So much for being a self-funded retiree.
You're facing a situation where not only are rates of return anaemic at best, but it's occurring in a backdrop of rising inflation as well, which is adding a real challenge around the real worth of income and the real value of people's retirement savings.
And it can be very frustrating for retirees and near retirees as well, because they can see what risk markets are doing. You can see how well you're being compensated for speculating, at a time where you're being absolutely punished as a saver.
And you can't do anything. We know you can't do anything because we've got core inflation pushing to near 3%.
So the corpus of your income is actually shrinking by that amount in real terms per annum. The amount of income you're earning is tiny and in all likelihood means you're having to increase your savings to stretch out your timeline and stretch out your capital.
So really, domestic investors, face an unprecedented challenge. And I think what might be a little bit more disconcerting to a lot of them is the fact that there's no clear end to it. There's no clear end in sight.
Why is it important for investors to be conscious of real returns?
The real rate of return is fundamentally important because it speaks to how much you've actually got left after inflation's gotten a hold of you.
The one really nice thing about being in a benign inflation environment is that your capital doesn't shrink in real terms, in inflation-adjusted terms.
It also means that your income is higher in real terms. But it doesn't take long for that rate of return to be whittled away by inflation, especially when rates are at absolute low levels, like they are right now.
So contextually speaking, why is the question of real returns versus nominal returns, which is the total return, why is it more important now than might have been the case two years ago, for argument's sake?
Well, for two reasons. One, inflation is trending higher, of course. But the other part of this is that inflation is trending higher at a time where rates are at record lows.
And you bring that together, and what it does, it puts savers in a really uncomfortable situation. So we're talking about inflation in the context of 2.8% — that's where core inflation is trending at the moment. Think about 2.8% inflation in the context of a cash rate of 0.1% and a special deposit rate for at-call money of 0.25.
So doing nothing right now is going to cost you minus 2.55% on your money. Okay? So think about what that means from an income standpoint. In real terms, the money just doesn't stretch any longer.
But think about what it also means for the corpus of your capital, or think about what it means for your portfolio in its entirety. The capital is also shrinking too. And what makes that a lot more problematic for a lot of people than people realise is that it then pushes the saver into a really difficult decision. Do you take more risk?
It's easy for some, but when you are in your 50s and 60s and your horizon is shorter, which is the case for a lot of savers, they're essentially in a position where they have to run their luck with an equity market that's cycling record highs, leave their cash at zero and see it shrink in inflation-adjusted terms, or perhaps find some kind of middle way.
And again, one of the key motivators for a lot of investors right now will be how they counteract inflation, which is exactly why the real yield and the real rate of return is so important.
What alternatives are there for investors who want to stop bleeding money in term deposits or taking risks in pricey equity markets?
It's not necessarily a time where you swing for the fences. In an environment where risk premia is sought after and credit spreads are at record tights, it is a time to be careful.
That doesn't mean, though, that there aren't some opportunities out there to offset the negative impact of inflation to allow your money to work a little bit harder.
So I think for a lot of people, the alternative is just sitting in cash and doing nothing. I think the question is, have you considered potentially taking some incremental risk to move out the risk curve a little bit?
We're not talking about taking a bounding step into longer duration credit, or riskier forms of lending or credit. We're talking about just doing a little bit more than nothing. And from that perspective, there are opportunities out there.
We have a short duration credit strategy — our Realm Short Term Income Fund — which is focused on high-quality financial services debt and corporate debt. And we are simply looking within that strategy to derive a rate of return of around 1.5% to 2%.
The way we do that is by being really broad in terms of the assets we look at by taking a disciplined, valuation-based approach.
And really what you want to do, especially when you're investing within the Australian market, is you want to minimise your idiosyncratic risk, which means you want to minimise your sector-based risk while giving yourself a bit of breadth; giving yourself diversity across a range of themes.
For example, RMBS (residential mortgage-backed securities) and ABS (asset-backed securities) — the residential mortgage-backed security market — is still presenting reasonable value down to a BBB attachment point.
Now, we're not talking about numbers which are going to excite the majority of the population. I completely understand that and that's very reasonable. But this is what we're talking about when we're saying incremental steps along the risk curve, rather than a really big bound.
From our perspective, a good alternative is to stay short. Stay within shorter maturities, focus on quality, take the return that's there without forcing it.
And you should be able to achieve a rate of return somewhere around that neighbourhood of 1.5% with a reasonably diverse group of high-quality credit assets. And right now, that might be the sweet spot.
And that's saying something, right? Because 1.5% would hardly have been thought of as a three-course meal from a fixed income or credit perspective half a decade or go. But we live in strange times, as they say.
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