SMSFundamentals | Jul 30 2012
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
For an introduction and story archive please visit FNArena's SMSFundamentals website.
By Greg Peel
Cash is still king among SMSF investors, and with due reason. Since the GFC and its subsequent fallout, longer term investors feel safer simply hanging on to their capital, rather than risking it. Equities are still the greatest proportion of the average SMSF portfolio, but at average levels of around 28%, cash has rarely been so popular. And why not? The banks are still offering very attractive rates on term and even access deposits.
As noted in FNArena's most recent SMSFundamentals report, "Credit – The Forgotten Asset", longer term investors in Australia have responded to the current risk environment by polarising their portfolios into two lumps – stocks on the one hand (mostly high-yield and blue chip) and cash/fixed income on the other. High risk/high reward potential on the one hand, and low risk/wealth preservation on the other. The report presents an argument for exploring an in-between range of risk/reward assets, but that is not to deny every balanced portfolio should hold an element of wealth preservation allocation.
The problem with holding cash and/or standard fixed income instruments for wealth preservation is that neither offers protection against inflation. You are receiving interest payments, but your face value investment remains the same. Over time, inflation erodes the purchasing power value or “real” value of this nominal value.
This is particularly the case with fixed income. Fixed income assets provide a fixed coupon payment which is locked in from the start. Your nominal investment is returned at maturity. If the instrument is freely tradeable, your investment will provide capital appreciation if rates fall and vice versa if they rise. The RBA will raise and lower rates based on inflation expectations. Inflation itself will reduce value if it rises and increase value if it falls.
The same is true for cash. However, term deposits are typically six months in duration and access accounts have no maturity so we're talking much shorter dates than bonds. There is thus an offset for inflation, because inflation will force the RBA to raise rates and banks will likely follow suit and raise their deposit rates. Thus each rollover, or each bank reset, will provide a higher interest rate to offset the inflation effect. But assuming a retiree is using the interest payments for income, the nominal value of a cash deposit will remain the same and thus its real value will fall.
In between are floating rate bonds, such as the subordinated issues currently popular with the banks. These typically offer a fixed interest rate margin over the bank bill swap rate, and the bank bill swap rate floats. Rising inflation will increase the BBSW rate, thus offering a higher coupon at the quarterly reset. Again – an offset to inflation but no inflation protection if interest is used for income.
So assuming we do want to hold a proportion of low risk, capital preservation allocation in our portfolios, which is sensible, how can we protect the “real” value of that capital?
Well, the traditional inflation hedge is gold. Inflation undermines the value of a paper currency thus by default making gold more valuable, or if you look at it another way, retaining the “real” value. However, gold pays no interest, so it cannot be used as a source of income. Recent years have also shown just how volatile the gold price can be at certain times, so it's not always a low risk asset.
Those wishing to invest in gold should look to ETFs such as ASX ticker code GOLD. Investing in gold miners is fraught with danger, albeit also with potential reward. Gold miners should be treated as stocks and nothing more.
Those not wishing to invest in gold would do well to consider inflation-linked bonds (ILB), issued by both the Commonwealth and State governments. As the name suggests, ILBs pay back the nominal face value of your investment plus an adjustment for inflation. Your purchasing power has not been eroded and you have still received an income stream.
“A 10-20% allocation to ILBs could provide much needed inflation protection and enhance capital growth,” suggested Tamar Hamlyn, principal of Ardea Investment Management, in a media release last week. Ardea offered up the following table:
The graph illustrates examples of very high levels of cash in a portfolio, but a lot of SMSF investors are doing just that at present. What the table illustrates is that ILBs can be used to either increase reward for risk, or to reduce risk for reward, on a “real” return basis.
It all sounds very sensible, and it is. But there is a little bit of a catch.
Firstly, having read this far you're probably thinking, in the wake of this week's historically low CPI result, that inflation is hardly worth worrying about at present. The disinflationary effect of post-GFC deleveraging from corporates and households, along with the threat of a global recession, has ensured such. However, we are talking longer term time horizons for SMSF portfolios. With inflation now at an historical low, the chances of even lower inflation into the future are diminished. The chances of recovering inflation down the track is much heightened from this low level.
“It's very difficult for inflation to move from 2% to 0%,” notes Ardea's Hamlyn, “but it's all too easy for inflation to increase to 5% and beyond”.
And let us not forget that global stimulus from central banks is inflationary, and at the moment is only countering the forces of deflation. There is more stimulus expected, and it is also expected that one day the deflationary forces will recede and that central banks will have a devil of a job controlling the potential of rapidly rising inflation. On that basis, ILBs in a longer term portfolio seem like a good idea.
The catch is that right now they are very expensive. About as expensive as they've ever been. This is manifested in historically low coupon payments. To buy a government bond right now, ILB or not, is to lock in a very low interest rate, particularly compared to what the banks are offering on cash deposits.
So we have a dilemma. ILB investment will protect against rising inflation, but given today's low inflation, and the interest rate differential and safe haven attraction globally of Australian government bonds, ILB's will not provide a lot of nominal income. The trade off is that real capital value will be protected on a rise in inflation.
A balanced portfolio is all about trade-offs, between risk and reward, between capital upside and income, between growth and capital preservation. For those shying away, or at least proportionately allocating away, from volatile equities, a mix of low risk assets offering trade-offs between income level and capital preservation is a means of achieving even greater balance.
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