Doug Turvey, Private Client Portfolio Manager at Cannon Asset Managers, looks at what investors should do now
Midway through 2015, the JSE All Share Index has taken a huge knock and the hunt for stable income sources for annuity investors continues. And it seems to be increasingly challenging. Most investors now face the task of matching their income needs with asset classes that provide stable income yields. In addition, investments need to keep pace with inflation and retain their capital value. Is this possible, given the volatility in the market today and that reported inflation does not always seem to reflect what the man on the street experiences? And what of the possible risk underlying these asset classes?
Many investors, particularly retirees and their dependents, rely heavily on living annuities to fund their lifestyles. Living annuities are, as their name suggests, intended to exist in perpetuity. This means that the capital invested in the living annuity should generate an income forever whilst hopefully retaining its value in real terms, so that the annuity can be owned by multiple investors over time. Historically, investors could achieve high and stable income levels from stable assets such as cash and bonds. These were appealing because they attracted no tax within the annuity (even though the income in the investor’s hands is ultimately taxable). Equities could be added for growth but were seen as being less relevant because of their volatility and relatively low dividend yields. The possibility of maintaining capital values and even growing them was good when including equities, and so the living annuity remained true to its name and intention.
However, over the last few years global interest rates have dropped considerably and look to stay relatively low, notwithstanding the potential for major economies to start raising rates. Annuity investors have found that real inflation has not dropped commensurately which eats into their lifestyle. Higher inflation is a very likely outcome, driven by the fact that there is more liquidity in the financial system.
In South Africa, the Reserve Bank’s monetary policy was focused exclusively on keeping inflation under control. It has now moved towards trying to balance the need for economic growth against the need to control inflation, therefore tolerating somewhat higher inflation while maintaining a relatively firm rate of growth. One of the key targets for this policy is South Africa’s persistently high level of unemployment, and it’s a bitter irony that higher inflation will be more immediately felt by no- and low-income families. Rising South African interest rates suggests that the Reserve Bank has a careful eye on inflation, but the fallout from the recent rout on the rand may yet thwart its efforts.
Beyond this, other risks have grown for the investor. In cash, the credit risk of the institution backing the investment has become a consideration. In the case of bonds, the governments backing them, in many places, are looking unstable and the yields are not worth the risk. Added to this is the capital risk associated with the bond as durations are extended. Not only are annuity investors facing a lifestyle risk in terms of falling income levels (perhaps one could call this a self–imposed austerity), they also face a risk of default: rising inflation will rapidly erode the value of any cash or bond instrument, which might be termed a “silent default”. This is most easily explained by the fact that you may get your initial capital sum back after the fixed term, but when taking inflation into account, that capital value is worth far less than it used to be.
What other asset classes can provide some stability? Corporate bonds can be attractive in well-funded institutions and this includes preference shares. Investors are, however, often surprised at the capital volatility that can be experienced by preference shares. Property yields are reasonable and fairly stable but will face the risk of rental defaults as tenants battle through the economic downturn. Although many new and existing lease agreements cater for a fixed rental escalation, providing an effective inflation hedge for investors, these leases are being negotiated and re-negotiated at lower rentals, which will obviously impact on the overall yield. In addition, some property prices are not growing in real terms.
The final primary asset class is equities. Is this the end of the hunt? The reverse of history seems true with equities in that relatively high equity yields can be found currently and these are not in stressed firms. On the contrary, many large, successful and well-established companies are offering attractive dividend yields to investors. An aspect that investors often struggle with is that equities often experience capital volatility, as we have recently experienced. However, buying the yield ensures that one still earns the same rand amount in the future, regardless of what the day-to-day price moves of the share may be.
It is worth noting that risk and volatility are not the same. Price movements don’t make a share more or less risky. It makes it more volatile. If your investment time frame is short-term in nature, then volatility is risky to you: risk is the chance that an investment behaves in a way that you did not expect. But if you intend to hold the shares for some time, that volatility does not present a risk to you.
When investing in equities it is vital to focus on their quality. Buying dividend yields that appear high, but are only high due to the firm being stressed, is detrimental to any portfolio. One should identify companies that have robust balance sheets, strong cash flow and sound governance. Research also shows that high dividend-paying companies are generally excellent capital appreciating opportunities.
In the current environment in which inflation is a threat, one should consider equities especially where companies can counter inflation by increasing the prices of their goods and services. And now that share prices have tumbled, the market presents an excellent buying opportunity.
Wise investors will control their emotions at a time like this. If your objective is to obtain stable income that grows in real terms over time, equities will become an increasingly important component of an annuity portfolio. And a diversification in investment styles could be important to create a smoother outcome if one needs to draw income.
So, don’t fear the sell-off in the market. If you are looking for stable income in the future look to equities and equity-centric yields – corporate bonds, listed property and preference shares – and be patient and realistic in your expectations.