Chasing yields

Your hardearned savings will waste away in a term deposit. Thankfully, there are other diversified investments that will provide a decent income

Record low interest rates are great if you’re paying off a mortgage or reducing debt but for those who need to live off investment income, including retirees, it’s been very hard. Leave your money in a bank account – where deposits up to $250,000 are guaranteed by the federal government – and your spending power goes backwards. But the alternative – shares and other better-paying investments – incurs more risks.

Term deposit rates have plummeted over the past year, with the average rates for terms between one month to five years falling between 0.47% and 1.05% in the year to June 2017, according to research from Canstar (see table).

Having a spread of different types of assets, including some cash, is the key. Diversifying your portfolio will help to buffer the risks involved.

Nobody wants to have to sell when share prices are falling because they need the cash

Retirees not wanting to erode their capital too quickly should consider having some of their funds in the sharemarket, particularly dividend-rich Australian stocks. It’s important to remember that share investing is not short term and you need to use money that you can lock away for at least three to five years. Nobody wants to have to sell when share prices are falling because they need the cash.

The Australian market is unique in that there are many companies that pay healthy dividends and also enjoy franking credits, meaning you can do much better than the measly returns from term deposits.

But for many, choosing the right stocks is far from easy, so it’s worthwhile considering a managed fund, exchange traded fund (ETF) or listed investment company or trust (LIC/LIT) set up to maximise yields. Fund managers recognise this and have been busy developing new investment vehicles for yield-hungry investors.

Risk-adjusted returns

First off the block are two listed investment trusts. These have a simpler structure than LICs and are similar to a property trust, except they invest in other types of assets rather than office blocks or shopping centres. LITs are a model that’s entrenched in the UK market but has not taken off in Australia, where about $33 billion has been raised by LICs.

The MCP Master Income Trust (ASX: MXT) aims to provide investors with income from Australian corporate loans. Its target return rate is the Reserve Bank cash rate plus 3.25% net of fees (4.75% currently). Distributions are paid monthly.

It’s the first ASX-listed investment trust to cover corporate lending, providing investors with exposure to a portfolio that reflects activity in the Australian corporate loan market, diversified by borrower, industry and credit quality. The trust initially will have exposure to over 50 individual investments with a near-term target of 75 to 100 individual investments.

Andrew Lockhart, MCP’s managing partner, says the trust presents a unique opportunity for investors to access an ASX-listed fixed-income investment. “The trust offers investors exclusive access to the highly attractive risk-adjusted returns available in the corporate loan market, historically only available to regulated local and international banks.

“Fixed income is a vital component of a balanced investment portfolio. Fixed-income investments offer predictable cash income with low risk of capital loss. We anticipate the trust will resonate strongly with retail and self-managed super fund investors, who have traditionally had low allocations to this asset class.”

Between 2000 and 2016, Australian corporate bonds generated a median return of 6.7% a year, with a high of 11% in one year and a low of 3%, with only cash offering lower volatility of returns.

Another new listed investment, the Magellan Global Trust (MGG), aims to provide investors a target cash distribution of 4% a year from a portfolio of 15 to 35 of the world’s best companies.

“We believe it is important that Australian investors diversify a meaningful portion of their equity investments into global equities,” says Hamish Douglass, co-founder, CEO and CIO of the Magellan Fund Group and portfolio manager of the new LIT. “The available investment universe in Australian equities is relatively narrow and, in our opinion, remains heavily dependent on the ongoing economic success of China, the domestic economy and the large Australian banks. Companies such as Alphabet [the owner of Google], Apple, Microsoft, Nestlé, PayPal and Yum! Brands are world leaders in their fields that have no equivalents on the ASX. Australians are familiar with these names because we use their products and services all the time.”

The trust aims to invest at a discount to its assessment of each company’s underlying intrinsic value. “We believe investing in such a portfolio should generate attractive investment returns over time while reducing the risk of a permanent capital loss,” says Douglass.

Distributions will be paid twice a year and MGG has specified its initial payments to provide unitholders with certainty. It will pay 3¢ per $1.50 unit each half year (starting in December 2017) in the first two years and after that set a 4% annualised yield based on a rolling 24-month net asset value and announced six months in advance.

“Smoothing” strategy

A feature of the Magellan trust that might not win favour with investors is a decision to cap “cash” distributions and force unitholders to reinvest “excess” distributions, says investment analyst John Kavanagh, from The Rub, an online publication aimed at retail investors.

Under normal circumstances, trusts pay out all income and realised capital gains to unit holders, says Kavanagh. But in years when the net income or net capital gains earned by the Magellan trust exceed the distribution target, the excess will be required to be reinvested as additional units through the distribution reinvestment plan (DRP).

Investors usually like to make their own call about whether they reinvest their returns and some might see this condition as a deal-breaker, says Kavanagh. “Another possible concern for investors is that when ‘excess’ distributions are reinvested they will not qualify for the DRP discount of 5% that Magellan is offering.”

A spokesman for Magellan told The Rub that the aim of the distribution strategy is twofold: to give investors a consistent and predictable yield through a “smoothing” mechanism and to use the DRP to support the unit price and thus avoid the problem of having the trust

trade at a discount to its net asset value.

One aspect of the Magellan float that was applauded by investment analysts was its decision to cover the cost of listing, typically about 2.5% for a LIC, to enable the trust to trade without a discount on debut. With MGG due to list on the ASX on October 18 we will soon know if this strategy worked.

Another new LIC, VGI Global Investments (VGI), also absorbed all establishment costs so that the securities would trade in line with their net asset value upon listing rather than a discount, as is usually the case.

VGI Partners, a high-conviction global equity manager based in Sydney and New York, is looking to replicate the methodologies employed by its unlisted VGI Partners Master Fund via the new LIC. It will invest both long and short in global equities. The portfolio managers will also employ a currency hedging strategy while aiming to deliver strong risk-adjusted returns.

Unlike the previous products outlined in this article this LIC is not aimed at providing regular income. “Delivering a high dividend is not a primary objective of the investment strategy or the manager,” says the prospectus. “The investment strategy’s primary objectives are focused on capital preservation and generating superior risk-adjusted returns over the long term. As a result, there may be extended periods where the company does not pay regular franked dividends to shareholders.”

Traditionally VGI managed capital for high-net-worth investors with the minimum application amount for their unlisted fund sitting at $1 million. The new LIC offers retail clients rare access to an investment vehicle managed by a team with a long track record.

The methodology has been successful, returning an annualised 14.6%, since it was established about 8½ years ago, outperforming the MSCI World Index (AUD), which returned 10.7%pa over the same period.

Another investment in the pipeline aimed at providing income as well as growth is Roger Montgomery’s first exchange traded managed fund (ETMF) to be quoted on the ASX. “The fund will mirror our very successful Montgomery Global Fund, offering access to extraordinary global companies not available through much larger global funds,” says Montgomery. The fund will also target a minimum annual distribution yield of 4.5%.

The Montgomery Global Fund, which was established in July 2015, returned 6.99%pa in the two years to July 2017, outperforming its benchmark, the MSCI Total Return Index, by 3.88%pa. Longerestablished products for investors seeking income include the Vanguard Australian Shares High Yield ETF (VHY) that had a total return of 11.42% for the year to July 31 and an average fiveyear return of 10.54%pa. Russell Investments’ High Dividend Australian Shares ETF returned 9.82% in the year to July (5.35% distribution return) and 11.06%pa over five years (5.69% distribution return). And two big dividend-seeking LICs, Clime Capital (CAM) and Wam Capital (WAM), are yielding 5.6% and 6.1% respectively. Because ETFs, LICs and LITs are listed on the ASX they are very liquid and you need only $500 to start investing in them.

Unlisted universe

There’s a lot more choice with managed funds but for some investors it’s too much, and the complications of buying and selling can also be a turn-off. Some managers have ASX-listed versions of their funds, called mFunds, but there are far fewer of these.

As an example, the Legg Mason Martin Currie Equity Income Trust has been a good long-term performer, returning 5.61% net over the year to July 31, 8.73%pa over three years and 13.25%pa over five years. The minimum investment is $30,000.

Mortgage funds are another investment generating higher returns than term deposits but these have had a chequered history so it’s important to choose carefully. LaTrobe’s 12-month term account (formerly the Pooled Mortgages Fund) has won Money magazine’s Best Mortgage Fund award eight years in a row.

LaTrobe was one of a handful of mortgage fund managers that made it through the GFC and it’s been in business for over 60 years. You can access this fund with a minimum of $1000 and all money is invested in cash or loans secured by first mortgages in Australia. It’s paying 5.2%pa and distributions are monthly.

Yield-hungry investors are embracing P2P (peer-to-peer) lending, even though it’s relatively new in Australia. RateSetter, locally owned but part of the RateSetter group founded in the UK in 2009, enables you to start with as little as $10 with lending terms of between a month and five years. Interest rates you receive vary but at the time of writing they were 3.8% for one month, 5.2% for one year, 7.8% for three years and 9% for five years.