Getting yield in a low-rate climate
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Nicki Bourlioufas is a Morningstar contributor.
As interest rates fall, so too will returns on term deposits. As investors look for other places to put their money, there are a range of fixed-income assets that can deliver healthy yields as well as capital preservation.
Fixed-income investments such as term deposits and bonds offer investors a relatively safe capital investment, a timely income stream, and reasonable returns for relatively low risk.
Not only that, some fixed-income assets, such as government bonds, perform better in tough economic times as investors demand safer assets with reliable income streams. This can help offset falling equities prices.
"If economic growth is getting worse, that's bad for the sharemarket. If interest rates then fall, that's good for fixed-income assets such as government bonds. The more interest-rate-sensitive the assets, the better they are likely to perform when rates fall," says Alex Prineas, a research analyst with Morningstar Australasia.
To date, the most popular fixed-income investments have been term deposits, where interest rates are set for a fixed term. Falling interest rates, however, mean investors are faced with reinvestment risk, that is, lower rates once it comes time to renew their terms.
The other problem with term deposits is they "don't act as a real diversifier within a portfolio," says Michael Dale, a portfolio specialist with PIMCO, which runs the world's largest bond fund.
"As interest rates fall, you get capital appreciation in a typical bond fund as some bonds, such as government bonds, become more valuable, but you don't get that with a term deposit," Dale says.
"There is also an opportunity cost. If, for example, you lock in an interest rate on a term deposit for three to five years and interest rates rise during that time, you'll lose the opportunity to reinvest your money at higher interest rates," he says.
Within the fixed-income spectrum, there are a range of assets that enable investors to diversify their portfolios and achieve healthy yields. While some bond funds invest just in government bonds, others invest in a range of fixed-income assets such as higher-yielding corporate or global bonds.
The main risk of investing in government bonds alone is that interest rates will eventually rise, causing bond prices to fall. PIMCO's Dale says a diversified bond fund may be a good option for investors who want to minimise interest-rate risk while still achieving stable capital.
"In a diversified bond fund, you get a healthy mix of government bonds, and corporate bonds. But you should choose an active fund manager who can allocate capital in either sector depending on their own macroeconomic outlook," he says.