As a general principle we advocate diversifying investments across a wide range of asset classes such as shares, property, bonds and cash. Shares and property are classified as growth assets as they have the potential to provide capital gains over the medium to longer term. Bonds and cash are classified as defensive assets as they are typically held in the portfolio to generate income in a relatively low risk manner.
When cash rates are low we typically see investors rotate out of cash and fixed interest products and into higher yielding share or property investments. This may be a reasonable strategy if done in a measured way where the change in asset allocation is not significant and not disproportionate to an investor’s propensity to take risk. However, where the rotation is significant, investors may be unwittingly increasing the risk of their portfolio significantly to chase higher income yields. Falling interest rates are typically a reaction to low inflationary expectations that are usually a by-product of a slowdown in economic growth. This means investors are increasing exposure to more volatile growth assets at a time when risks for these growth assets are increasing. Of course this can be disastrous if markets correct and the investor does not have the financial means or time scale to withstand any prolonged fall in capital values.
Another common concern is where investors increase the risk within their basket of defensive assets, cash and bonds. Often investors will rotate out of term deposits and into instruments they perceive as low risk such as hybrids, which have both debt and equity like characteristics. In a benign market environment hybrids typically behave more like a debt instrument; investors receive a regular income distribution with little movement in capital value. In an environment where markets dislocate, these instruments can not only fall sharply in value but issuers can exercise their discretion to cease dividend payments (act more equity like).
Similarly, it is not uncommon for investors to rotate out of low yielding bond instruments when rates are falling. While income yields on government, semi-government and investment-grade corporate bonds may be low, bond prices are inversely related to interest rates. As interest rates typically fall in a depressed environment, when share prices may also be falling, bonds can rise in value. This appreciation helps offset losses on other assets, providing a valuable hedge to an investment portfolio.
These risks can be amplified when investors rotate out of lower yielding investment-grade bonds and into higher yielding ‘junk’ bonds when economic conditions deteriorate and rates are falling. This is because the credit or default risk of these bonds typically increases under these conditions.
In summary, it is important to understand the consequential risks of chasing yield in a low interest rate environment. In some circumstances it may be better to adjust income or lifestyle expectations rather than increase risk. The appropriate course of action will depend on the individual needs, financial circumstances and objectives of the investor. The vulnerabilities of any financial strategy are only exposed during times of crises.
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