Which asset classes to consider for an income-producing portfolio?
Words on Wealth:
While working people invest to accumulate savings, there is a large group of people – mostly over the age of 65 – who have invested the savings accumulated over their working years to provide an income. The second type of investment is very different from the first.
The return on an investment is made up of its income yield and its capital growth. The distinction between the two is often downplayed by asset managers and you rarely see a breakdown on fund fact sheets.
Yield is interest in the case of bonds and cash, dividends in the case of equities, and rental income in the case of property (or rental-related dividends in the case of listed property). Capital growth is the appreciation in the asset’s market value: the price of a share, bond or property.
While yield may fluctuate – for example, a company may reduce or withhold dividends in times of crisis, as many have this year – it is generally far more stable than price, which is subject to the volatility of the financial markets.
An ideal income-producing investment would be one in which your capital remains untouched, and you live off its yield, which should keep pace with inflation. On such an investment, you could live indefinitely. (For the sake of simplicity I am ignoring the fact that our expenses change as we age.)
Let’s look at how the different asset classes would weigh up in such a portfolio, taking into account our turbulent times:
Inflation is very low at the moment – at just above 3%. This presents a mixed blessing for retirees: the prices of goods may be rising more slowly, but interest rates have fallen to rock-bottom levels. Having your savings in a cash investment such as a money market fund or bank deposit will not only provide a low return; your income will be reduced further by inflation, low as that is currently. What happens if inflation suddenly rears its head? If you’re stuck in a fixed-term deposit, you’d face the double-whammy of low returns and high inflation.
A little while ago I pointed to the excellent rates currently offered by RSA Retail Savings Bonds. These are particularly attractive if you’re drawing an income: on the inflation-linked bonds, you get 4.5% on the five-year bond and 5% on the 10-year bond, with your capital adjusted each year by the Consumer Price Index inflation rate.
Government bonds are offering exceptionally high yields at the moment (the yield on the 10-year bond is 9.5%), making them attractive to fund managers such as Lourens Coetzee, an investment professional at income-focused asset management company Marriott.
Higher bond yields reflect a higher risk of a debt default, but Coetzee believes South Africa’s risk of default is lower than its bond yield suggests. He says South Africa faced a “perfect storm” earlier this year, enduring both a credit rating downgrade from Moody’s and Covid-19, and this has led to us being “out of sync” with other emerging markets. For example, Moody’s rates Brazil a notch lower than South Africa, and its debt-to-GDP ratio is higher than ours, but its 10-year bond yield is lower, at 7.2%. Nigeria’s 10-year bond yield is also lower than ours, at 8.7%, but its debt problem is bigger: more than 40% of government revenue is spent servicing debt, about double what South Africa is likely to spend this year in the midst of the crisis, and far above even the gloomiest predictions of economists.
“Having said that, we remain concerned about the trajectory of government debt-to-GDP and expect a continued deterioration in the years ahead despite Tito Mboweni’s best efforts to rein in government spending. So we think you can go to local government bonds as a place for yield over the next six to 10 years – we don’t believe a default event is likely over that period,” Coetzee says. Reasons include our relatively low level of foreign-currency-denominated debt, the average term of government debt being approximately 12 years and the fact that the government has a last-ditch option to print money to service debt.
Traditionally, listed property in South Africa has provided a strong source of income. However, this sector entered a crisis a year or two ago, and Covid-19 has only made things worse, with returns for the year to date at -44.7%
Coetzee believes that, despite the pressures this sector is facing, the market has overreacted to the downside, and if one is selective, there is a case for investing a portion of an income-driven portfolio in listed property. Taking into account the impact of Covid-19, investors can nonetheless reckon on about an 11% income yield from this asset class longer term, he says.
Again, there are pockets of opportunity – for yield in local equities and for growth (in both income and capital) offshore. “The markets are depressed and are pricing in the tough times, but you should get decent yields from local companies that are well-managed, have strong balance sheets and are well positioned to bounce back after the crisis,” Coetzee says. However, economic growth will not reach pre-Covid levels for some years, so you should not be expecting much growth in the local stock market. For that you should be looking offshore at companies that will benefit from three key trends: ageing populations in the developed world, rising incomes in the developing world, and technological progress enabling greater efficiencies.