My kids love the game: what superpower would you like to have? I sometimes answer: time travel. Imagine being able to travel to the future, know what is going to happen, and come back and prepare for it. To be able to invest knowing what is going to happen. The returns could be out of this world. Unfortunately, I nor anyone else I know, have that super power. In fact, recent experience has taught us how quickly things can change and how impossible it is to really know the future.
When it comes to predicting inflation and the subsequent interest rate we can expect to earn on our investments the experts are struggling. Our RBA governor Philip Lowe said in October 2021 that inflation will not rise above 3% before 2024 and he is the Australian expert. With inflation at 7% pa in May 2023, he was a long way out.
Trying to time the market to maximise returns is very difficult and often ends in failure because of this very issue: we don't know the future.
So if we don't have super powers and the experts can't help us: what can we do to position our income portfolio for the future?
We can look at what scenarios could happen and prepare for them.
History can show us what has happened before but it can't tell us what will happen. The graph below shows that since 1976 interest rates can change quickly or slowly. They can plateau. They either go up, down or sideways. The main issue is the speed of the change.
Source: RBA Historical Interest Rates
Given that interest rates can only go up, down or sideways, we can prepare a strategy for each of those scenarios and weigh them according to where we are in the cycle.
The below scenarios address strategies for investing in these 3 different interest rate scenarios:
Scenario 1: Interest Rates Spike and Drop
The interest rates could continue to rise during 2023 then begin to fall early to mid 2024 due to economies going into a recession.
This will result in income investments continuing to climb in returns and those that lock in rates before the interest rates fall will benefit from continuing higher income whilst others will have to take the lower rates as they flow through.
Strategy 1: What are we doing to prepare for this scenario? We are looking for quality high yield income investments offering higher income yields such as 15% pa income. We have a couple already and are searching out others. We are not limited to Australian only investments, we directly invest globally and can hedge the currency giving us a much larger pool of potential investments compared to just Australia.
Scenario 2: Interest Rates continue to rise
Rates continue to rise and stay high through 2024 and into 2025
Many of you will remember the interest rates on the chart above where the cash rate was close to 20%. It was a terrible time for people with debt. For those with fixed interest investments they also suffered if they had to cash in their investment early and take lower capital returns. It is like cashing in your term deposit early and having a penalty of no interest payments and/or fees.
Strategy 2: We are looking for high yielding income investments however mixing in floating rates and/or shorter term investments. Floating rates will enable us to benefit from continually rising rates. Shorter terms will mean that we can roll the income investment to a higher rate.
We also look for income opportunities with different time horizons but limited to those we can hold to maturity. This will enable us to ride out any movements in capital values because of an increase in interest rates. In a rising interest rate environment, where you have to sell your investment on the market before maturity, it can result in capital erosion. We avoid this scenario by investing directly in investments which we can hold to maturity.
Scenario 3: Interest Rates plateau
It may take a decade for us to lower inflation and interest rates. We may be entering a sustained period of higher interest rates. This will mean that margins for returns on taking risk will expand. The last decade has seen the risk margin compress and many not earning sufficient return for taking on higher risk in income portfolios. Thus many remained in cash.
Strategy 3 In all scenarios, we look for income investments with lower risk than what has been priced in and the reward more than compensates for the risk. The good thing about the plateau scenario is it will pay higher rates of return for longer holding periods so we can match investments to time horizons and be adequately rewarded for the longer time period. We would still look to only invest in income investments where we can hold to maturity and not be penalised for rising rates by cashing in early.
Which scenario are we likely to experience?
Based on the graph below, the market is pricing in interest rates going sideways until mid to late 2024 and then declining but taking a few years to run off. The chart below shows interest rates for the 5 year US Government (blue line) bonds and the Australian government (red line) bond as at 15/06/2023. Now these figures change and reflect a moment in time however they do indicate what the market is thinking at that moment.
Source: Bloomberg 15/06/2023 8.52pm EDT
Normally, the longer the term of the income investment, the higher the interest rate paid. Think a term deposit rate of 12 months vs 5 years - it used to be higher for 5 years. This graph shows the opposite: the longer the term held, the lower the rate being offered as at 15/06/2023. This is an indicator that the market thinks the interest rates will be lower in 5 years than they are presently.
However, this rate changes daily. See the graph below for the 5 year US Bond rate for the 6 months to June 2023. The rate peaked at 4.40%, dropped to just below 3.40% and then has climbed again to 4.00%.
Source: MacroTrends
As this graph shows, the forecasts for what the rates will be in 5 years changes daily. This makes making firm predictions difficult. However, incorporating strategies into your portfolio to accommodate for the various scenarios can help you experience lower stress and higher returns. As the old philosopher Seneca once said "Luck is what happens when preparation meets opportunity." Learning about how to position your portfolio for a range of scenarios can set you up for recognizing great opportunities that may later appear lucky to others.
For example, those who locked in 5% p.a. interest rates in 2007 for 10 years enjoyed a decade of higher returns on their income investment whilst others watched their returns dwindle away. It would be nice to be considered lucky wouldn't it?
The first step in being prepared is research and learning. To help you to learn more about income investment opportunities on top of their term deposits, we are running a free 1 hour webinar where we will discuss our recent income investments earning up to 15% pa return and where we see further opportunities. We will also discuss the various options available and how to assess their risk and return. You will be able to ask questions and glean information to help double check your current investments. We of course will not be able to make any recommendations but it is a great opportunity to directly speak to a professional portfolio manager about market conditions and opportunities.
If you are interested in learning and earning more from your income portfolio, sign up for the webinar here. Even if you can't attend on the day, we will be able to send you a link to the video and include you in future updates (if you would like).
Alternatively, if you would like recommendations relevant to you, please contact us on 02 8013 5205 or via the contact us form below.