How To Invest When Rates Hit Rock Bottom

One of the best investment books I’ve read this year, The Australian Guide to Fixed Income, by Fiig Securities, briefly outlines a few key strategies for when the economy and official cash rate reach the low point in the cycle – a topic that will becoming increasingly timely over the next 18 months.

How to invest when rates hit rock-bottom is an important issue for all investors, especially retirees and conservative investors who rely on income from cash or fixed or floating-rate investments to survive. Increasingly, income-seeking investors are buying high-yield shares, even though that strategy has higher risk.

For the record, we still have a way to go before the official cash rate bottoms and the market focuses on a rate increase. I still expect another two quarter-point interest-rate cuts by March next year because the rest of the economy is not growing fast enough to absorb the mining investment slowdown. More likely is inflation contracting as the economy slows and unemployment rises.

But we are close enough to the bottom of the rate cycle for investors to at least think about subtle shifts within the fixed-income component in their portfolio – if not act on them just yet – and position for an eventual increase in interest rates and, more importantly, safeguard against the threat of rising inflation and reduced purchasing power.

Fiig’s fixed-income guide suggests five key strategies at the low point of the interest rate cycle: sell fixed-rate bonds and buy floating-rate notes; keep some fixed-rate bonds to protect income; add inflation-linked bonds; add risk to fixed-income portfolios; and redeem bank term deposits to buy floating-rate notes or inflation-linked bonds.

The third strategy – add inflation-linked bonds – is particularly relevant for retired investors who need to protect their income against higher living costs in the long term.

Inflation-linked bonds are linked to the Consumer Price Index. As the CPI rises or falls, so does the capital price of the inflation-linked bond, meaning the bond acts as a direct hedge against the risk of higher living costs. For example, if inflation was 3 per cent, the capital value of the inflation-linked bond would rise by 3 per cent.

Yes, with Australia’s annual CPI running at 2.4 per cent, and the economy contracting, the risk of sharply higher inflation seems moderate at best. But headline numbers don’t always tell the whole story. Rising gas, electricity and water bills, and higher healthcare costs are key challenges for retirees living on fixed incomes. Many don’t have scope to cover higher-than-expected price increases and combat cover-of-living pressures because their investment income is not rising fast enough.

Globally, central banks in the largest stgeloped nations continue to print money to prop up their sagging economies, which in turn increases the risk of a medium-term breakout in inflation. As the US Federal Reserve finally tapers its quantitative easing programs, a rising US dollar could drive the Australian dollar lower, which in turn will lift import prices and feed into potentially higher inflation.

Predicting what will happen on inflation is fraught with danger and nobody is suggesting a return to bouts of double-digit inflation, as seen in the 1970s and 1980s. But there’s enough evidence to suggest retired investors should consider adding inflation-linked bonds to their portfolios to safeguard against the threat of higher inflation and living costs in the next three to five years.

As Fiig notes in its guide: “Runaway growth can lead to an inflation spiral. In slowing, or bottoming economies, governments are under pressure to stimulate economic activity through direct or monetary policy intervention. If the government gets this wrong, overstimulates or stimulates for too long, upwards inflationary pressures can result.”

Fiig adds: “While investors would not have experienced high inflation for some time as the economy had been contracting, at the low point an economic cycle it is a good idea to add inflation-linked bonds to your portfolio. Buying at the low (with the possibility of buying at a discount) makes sense before the risk of inflation heightens. Inflation-linked bonds can also be an excellent investment in a low-growth economy. They know set margins above the Consumer Price Index can be attractive when interest rates are low for long periods.”

Choosing the right inflation-linked bond for your portfolio has become easier following the launch of five Commonwealth inflation-linked bonds, or Exchange-Traded Treasury Index Bonds via ASX in late May. Being listed on an exchange makes these bonds much easier to buy and sell.

Inflation-linked corporate bonds from Sydney Airport, Envestra and ElectraNet other options, although they are bought in over-the-counter markets. These bonds have higher coupons than their government bond peers, and higher risk.

The government bonds pay a small margin in addition to CPI (less than 1 per cent for some). But certainty of income and repayment of the principal amount at a known date – and the knowledge that the bond’s value is keeping up with inflation – will be a sufficient trade-off for many older investors. Owning government bonds has added appeal for risk-averse investors and money is not being locked away for long periods in term deposits.

Sadly, bigger increases in healthcare and utility costs seem inevitable in coming years, meaning conservative investors should take steps in the next 12-18 months to ensure their income – and lifestyle – is protected from the risk of rising inflation.

–     Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their financial adviser before acting on themes in this article. All prices and analysis at August 28, 2013.