Taking a total-return approach when rates are low

With the Reserve Bank of Australia (RBA) cutting the official cash rate to just 1.00% on 2 July and further interest rate cuts forecast by financial markets, retirees and investors face increased challenges in deriving enough income from their investments to meet their needs. This low-interest, lower-return environment may tempt some income-focused investors to abandon carefully diversified portfolios in the pursuit of higher income.

However, this often involves investing in a higher-risk and lower-quality portfolio – without the benefits of proper diversification. Watch out for the traps of becoming an income-chaser.

Given this low interest rate environment, income-oriented investors have three broad choices:

  1. spend less;
  2. reallocate their portfolios to higher-yielding investments; or
  3. spend from total returns instead of income alone.

Given that spending less is generally not a desirable option for most clients, we think it makes more sense to focus on the second and third options.

Higher risks associated with chasing higher yielding investments
Income-chasing investors may be tempted to reduce their exposure to high-quality bonds and broad share portfolios to increase their allocation to higher-yield, higher-risk bonds, hybrid investments and more concentrated portfolios of high-yield shares. Higher-yield shares are often concentrated in financials and utilities.

Unfortunately, not all investors would recognise and appreciate the higher risks involved when moving away from carefully constructed and broadly diversified portfolios with asset allocations that reflect their tolerance to risk and their long-term goals.

Investors who shift some of their fixed-income portfolio into higher-yield shares carry the risks of higher volatility and greater potential for capital loss.

A critical role of quality bonds is to act as portfolio diversifier and a buffer to share market volatility– not solely to produce income. Movements in bond and share prices typically have a low correlation. Don’t overlook the diversification role of bonds when interest rates are so low.

Adopting a total return approach
Given that the income only strategies mentioned above could be damaging to your portfolio’s overall health, we recommend our clients take a total-return approach to investing as an alternative to being an income-chaser. Total-return investing focuses on both the income and capital growth generated by diversified portfolio.

Keep in mind that the income-only and total-return approaches are identical to a point—that is, under each method investors spend the income or yield generated by their portfolio. It is only when investors need additional monies from their portfolio that the investor often faces a decision and the approaches diverge. The spending gap can be filled either by overweighting income-producing assets or by spending from the other piece of the total return, namely, capital appreciation.

A total return approach provides several advantages compared to an income only approach:

  • Helps to maintain a portfolio’s diversification (investor risk exposure)
  • Allow more control over the size and timing of eventual drawdowns in retirement
  • Allows the portfolio to be more tax efficient and
  • Increases the portfolio’s longevity

Many investors, particularly retirees, try to base their retirement spending solely on the income produced by their portfolios. This can lead to retirees becoming income-chasers or too frugal given the state of their finances.

Moving away from a broadly diversified portfolio and concentrating on certain sectors can potentially result in a less diversified portfolio, increased risk, decreased tax-efficiency and/or an increased chance of falling short of long-term financial goals. On the other hand, adopting a total-return approach focuses on the entire return earned by the portfolio rather than its individual components. As discussed above, it provides several important advantages compared with an income-only method.

If you have any questions/thoughts in relation to this article or would like more information, please click here to send us a brief email.

This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial and tax/or legal advice prior to acting on this information. Before acquiring a financial product a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product. The material contained in this document is based on information received in good faith from sources within the market, and on our understanding of legislation and Government press releases at the date of publication, which are believed to be reliable and accurate. Opinions constitute our judgment at the time of issue and are subject to change. Neither, the Licensee or any of the Oreana Group of companies, nor their employees or directors give any warranty of accuracy, nor accept any responsibility for errors or omissions in this document. Gordon Thoms and David Conte of Calibre Private Wealth Advisers are Authorised Representatives of Oreana Financial Services Limited ABN 91 607 515 122, an Australian Financial Services Licensee, Registered office at Level 7, 484 St Kilda Road, Melbourne, VIC 3004. This site is designed for Australian residents only. Nothing on this website is an offer or a solicitation of an offer to acquire any products or services, by any person or entity outside of Australia.

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