Generally speaking, interest rate cuts are beneficial for investors and borrowers, however, there is a negative flip side.

As the population ages, retirees are seeking a steady income from their retirement savings to travel, pay the bills and generally live a comfortable life without incurring major investment risks.

Traditionally, retirees and those approaching retirement are likely to utilise a “lifecycle investment” strategy where older investors protect their assets from share market volatility.

The rationale of “lifecycle investing“ is that younger people can afford to take on more risk in return for higher long-term rewards because they have time to ride out the inevitable market ups and downs. As people age and get closer to retirement, capital preservation becomes a higher priority.

Traditional defensive investments that offer income and stability are Term Deposits and cash trusts. However, with the recent further cut in interest rates to historic low levels, the income return from these traditional investments do not even cover the basic needs of many retired people.

Against that backdrop, there are alternative income products which are also listed on the ASX including:

Bank Hybrids

Hybrids are part of a bank’s regulatory capital and rank one step above shares should the bank default.

Hybrids are a unique security that combine characteristics of a debt security and those of an equity. They have a call date where the issuer may redeem the security and they pay a distribution at regular intervals.

However, these securities are also designed to convert into equity of the issuer should the issuer meet times of distress, which explains the comment that “hybrids look like a bond in good times and an equity in bad”.

Key features:

  • Distributions are paid quarterly or half-yearly
  • Distribution payments are discretionary, similar to equities
  • Distribution restriction/non-payment prevents dividends to ordinary shareholders
  • Perpetual, however, the issuer has an exchange option after 5 to 6 years
  • Automatic conversion into equity under a trigger event
  • A non-viability clause

Additional risk for additional income
Bank hybrids are not a bank deposit and are not protected by the Government guarantee scheme. They are ASX listed and subject to movements in credit spreads.

LISTED INVESTMENT TRUSTS

Listed Investment Trusts (LITs) provide investors with the opportunity to gain exposure to a portfolio of a broad range of assets that trade on the ASX. LITs operate in a similar manner as a managed fund as they have a manager, internal or external, who is responsible for the selection of investments and management of the LIT.

A LIT and a Listed Investment Company (LIC) will differ when it comes to income payments. LITs are trusts and must distribute any surplus income to unitholders, whereas a LIC is able to retain income and build profit reserves over periods before paying dividends to shareholders. A LIC has a greater ability to pay fully franked dividends as franking credits are obtained from the credits attached to the distributions of the securities in the underlying portfolio and from tax paid on company earnings. A LIT’s distributions will only carry franking credits obtained from the underlying holdings as the tax obligations are passed through to the unitholders.

LITs can be beneficial for managers as they are closed-end funds. This means that the managers have a fixed amount of capital after the IPO, without the worry that large redemptions of units may negatively impact the investment portfolio in the future.

Risks

  • Underlying securities may be susceptible to adverse economic or regulatory conditions that negatively affect the sector and the companies comprised in these portfolios, which may result in the default of underlying loans.
  • LITs are not redeemable at the Net Asset Value (NAV), and may trade at a discount to the NAV.
  • Trading occurs on the ASX and is subject to having sufficient liquidity, which at times may not be present.
  • A LIT could unexpectedly terminate, change its fees and expenses, or the responsible entity may be replaced by another entity.
  • Key personnel from the investment manager may leave.
  • Past performance may not be an accurate indication of future performance, nor should it be relied upon when making an investment decision.

EXCHANGE TRADED FUNDS

Exchange Traded Funds (ETFs) are open-end trusts that trade on the stock exchange, combining the liquidity of shares with the diversification of managed funds. Open-end means ETFs don’t have a fixed amount of capital and funds under management may grow through unit creations or reduce via redemptions. An ETF provider will employ Market Makers and Authorised Participants to manage the daily market liquidity and the creation or redemption of underlying units depending on market activity.

ETFs are commonly passive investments that aim to track the performance of an underlying market capitalisation weighted index. More recently there has been a rise in ‘smart beta’ ETFs, which employ rules based strategies to indices. This provides a blend of active and passive investments that tend to focus on factors that seek to add value beyond the traditional index exposure.

An Exchange Traded Managed Fund (ETMF) is similar to an ETF with an active manager that seeks to outperform a relevant benchmark over the investment time frame.

Like an LIT, tax obligations are passed through to the unitholder and all surplus income in each period must be paid out in distributions.

Risks

  • Historical performance is no guarantee of future performance, and cannot be solely relied upon in evaluating a manager’s ability to provide value.
  • There is no guarantee that the strategy of a fund will be executed by the manager/provider successfully or will deliver in meeting its desired objectives.
  • Investors should understand the objective of the index and in particular the selection criteria and methodology of individual weighting in the benchmark.
  • There is no guarantee that the benchmark used will meet its objectives or produce a satisfactory return.
  • The price at which the units trade on the ASX may not accurately reflect the NAV at a particular point in time. The role of the market maker will be to minimize the tracking error, not to eliminate it.

LEARN MORE

If you’re interested in learning about these investment opportunities in the context of your portfolio, get in touch with your Bell Potter adviser. Alternatively, call 1300 023 557 to organise an obligation free discussion with one of our experienced advisers.

Published on 17 July 2019
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