In a low yielding investment environment smart investors can still boost their returns by taking on carefully selected risk as part of a diversified portfolio.
Three ways that an investor can take on higher risk are by agreeing to part with their money for longer, by accepting weaker rights over the issuer’s assets, or by investing in companies that are more at risk of failure.
The first of these ways, longer terms until maturity, is something that most people will be familiar with from term deposits. These usually pay a progressively higher interest rate as the term increases. A few years ago, this simple strategy was good enough to generate a high medium term return. For instance, Westpac investors were paid an 8 per cent fixed rate return for handing funds over for five years.
Unfortunately, it is not that easy any more with the incremental increase in return for committing to a longer dated term deposit now marginal. A good major bank term deposit rate for one year is around 3.4 per cent, while the five year rate is 3.9 per cent, although a higher 4 per cent if you have at least $500,000 to invest.
If investing for longer is your strategy, bonds now offer a better proposition. For example the Dampier to Bunbury Natural Gas Pipeline joint venture has a bond maturing in September 2015 with a yield to maturity of 3.7 per cent and another bond maturing in five years in October 2019 with a yield to maturity of 4.76 per cent. The extra yield of 1.06 per cent is compensation for investment in the same company over the longer term given there is less certainty about the performance of the company. There is a greater chance something will happen to it, whereas the closer to maturity the more certainty there is for investors.
This theory holds true across all asset classes. Hybrids with longer terms until first conversion or redemption, that if missed can then be perpetual, are greater risk than those with earlier calls and defined final repayment dates.
The second way to get higher returns is by investing in securities lower in the company capital structure, which exposes you to more risk in the event that it fails. Each bank and company has a capital structure which shows the priority of payments in the event of a wind-up. Investments at the top of the ladder are repaid first, while those at the bottom take on the losses first and are most likely wiped out.
This has been a popular option. Swapping major bank term deposits for their shares has delivered great returns over the last year, but there are a number of rungs in the capital structure with varying risks in between that can deliver higher returns without going from one of the lowest risk options to the highest.
The third way to boost returns is to replace investments in low risk companies for companies that are higher risk. Theoretically, across the bond, hybrid and share markets investing in higher risk companies should deliver higher returns. Some of the best returns available in the bond market are from companies that are not rated by credit rating agencies, or rated sub investment grade. Investors can earn much higher returns of over 6.5 per cent but take on higher risk of default or non payment by the company.
A word of caution, returns are directly correlated to risk. The higher the risk, the higher the return should be. It’s very important that you understand what the risks are and make a judgement of the incremental return you need over the lower risk options to compensate.
