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As a financial adviser, you’ll likely have clients invested in cash or income-type products which are yielding far less than they were just one year ago. The lower yields are probably a source of frustration and may be throwing the attainment of your client’s financial goals into doubt.
Is the low yield environment here to stay? If so, what does that mean for your clients? And how can you assist them in achieving their financial goals – by making sure they are in investments that are in line with their risk appetite?
These were the three key topics covered by Bronwen Trower, a Fund Manager at Investec, during the recently aired Financial Planning Summit. We offer insight into her thinking…
Are low interest rates likely to persist?
For some time, South African investors had the luxury of high interest rates. Historically, this meant that your advisory clients have been able to earn good real returns without much risk. But the economic fallout caused by Covid-19 and the accompanying lockdowns have forced central banks around the world, including the SARB, to reduce interest rates dramatically.
While our longer dated South African bonds still have attractive yields, the risk involved in holding them has increased significantly. How long will we have to deal with lower yields?
The majority of CEOs around the world expect a U-shaped global economic recovery; the next most popular belief is in the longer, more damaging L-shaped revival. If their sentiments prove correct, then we’ve probably got another two years, at the very least, before central banks begin to think about raising interest rates.
In addition to the above, there are other fundamental realities such as dampened economic growth and aging demographics, which will likely keep developed market interest rates low for the foreseeable future.
If central banks in developed markets keep their rates near zero for the next few years, and the global economic recovery is gradual rather than rapid, then there’ll be little reason for the SARB to raise our interest rates. That means a lower-yield environment, for longer.
Beware of the dangers of ‘reaching for yield’
Anchoring is a well-documented human behavioural bias. In the context of your client relationships, it means that those you advise will be tempted to take on more risk to restore the yields they were earning before the Covid-19 hit. Their expectations, and their behaviour that flows from them, are heavily influenced, or anchored, by their historical returns.
The danger here is that your clients’ insistence on having their previous yields restored by taking on risk, may not be appropriate in the context of the financial plan you’ve meticulously put together for them. This is also known as ‘reaching for yield’.
Reaching for yield infers that your client may favour a riskier asset than their appetite allows in order to sustain yields they were historically used to. This behaviour may result in investors taking excess risk, inflating the price of riskier assets and essentially deviating from their financial plan.
Meaningfully changing your client’s well-thought-out asset allocation to include riskier assets – with the hope of making up for lower yields on cash and income investments – therefore comes with the added risk of entering an overcrowded trade.
By co-investing, you essentially have a partner in the fund who has the skills and resources to thoroughly evaluate opportunities and whose actions to protect their own capital will help to protect the capital you invest on behalf of your clients.
Two ways to increase yield without introducing unsuitable risk
Your clients may be frustrated by lower yields, but you know that increasing their exposure to riskier assets like equities might not be appropriate, given their situation. What are your options? There are two alternatives that may help to placate your client’s thirst for yield while ensuring you uphold your fiduciary duty to manage their money prudently.
Co-investing in private credit fund
According to Trower, adding a private credit fund to a client’s existing portfolio of income generating assets/funds can help increase the yield of the overall portfolio, without materially increasing risk. The benefits of a private credit fund are as follows:
- Higher absolute returns due to specialised risk taken
- Attractive relative returns when paired with traditional income funds
- Income earned from cash interest coupon
- Low relative volatility/losses
- Low correlation to public debt and equity
- Structural protection (covenants) and conservative structures to navigate through cycles
Trower cautions those interested in adding a private credit fund to their client portfolios:
“It’s a specialised asset class, so it would be prudent to co-invest alongside someone who knows their way around a private credit fund, like a bank, or an origination party. To access private credit funds is preferably through co-investment, as it provides you with an element of comfort.
"By co-investing, you essentially have a partner in the fund who has the skills and resources to thoroughly evaluate opportunities and whose actions to protect their own capital will help to protect the capital you invest on behalf of your clients.”
Add preference shares
Not quite debt, not quite equity, preference shares fall somewhere in between the two traditional asset classes and are a great tool for increasing the yield on your clients’ portfolios. They augment interest income earned by adding dividend income to the mix, without materially increasing risk. The characteristics and benefits of preference shares are as follows:
- They usually earn a higher income than debt holders to compensate for the marginally higher risk.
- Investors are guaranteed a predefined dividend percentage pay-out if the company makes a profit and most often receive dividends before ordinary shareholders.
- Preference shareholders are second in line to receive their capital (behind debt holders, but before equity holders) if the issuing company is not able to meet its obligations.
Trower states that or those who are considering an investment in this asset class should carefully compare listed or redeemable preference shares, to the perpetual variety as perpetual preference shares may exhibit higher capital risk and volatility.
She adds that as an alternative, those advisers appropriately licensed and comfortable using structured products, can add lower risk pay-outs to their clients’ portfolios.
Find the middle ground
We understand the pressures that South African financial advisers are under at the moment; creating and amassing wealth in South Africa was challenging enough before Covid-19 wreaked havoc.
In a low-return environment, which will probably be with us for several years, the temptation is to take on additional risk in order to generate the returns your clients expect.
However, there are creative ways to help you earn more income for your clients without increasing risk beyond what’s appropriate. As a middle ground, carefully adding co-investment opportunities from a private credit fund or including preference shares in your client portfolios are both options worth considering.