An ageing population and a shift in focus to less volatile and more sustainable returns has put the spotlight on investing for yield. The search for assets providing decent investment yield is a never ending one.
This is especially relevant presently given both short term and long term yields have reached record lows in the last twelve months and, even though yields have risen recently, they are still not all that far away from what are multi-decade lows.
The official cash rate is currently at 1.50%, 3 year Commonwealth bonds yield around 1.60% and ten year Commonwealth bonds yield about 2.50%. These rates act as reference rates for all other rates in Australia and, as such, the fact they are at low levels means pretty much all other interest rates or yields are as well. However, these reference rates come from a AAA-rated issuer; the Commonwealth Government. Other issuers and deposit-taking institutions are technically not as safe as the Commonwealth and hence their rates and yields will be a margin higher than these reference rates.
The size of this margin is a function of how much additional risk the issuer or provider represents over and above the risk the Commonwealth represents. For cash accounts and short-term deposits offered by a major bank, the additional risk is viewed as small and thus the rate offered will be close to the official cash rate. For a three year term deposit, the rate will be close to the yield on a Commonwealth 3 year bond.
Only through investing in deposits or products offered by institutions can you start to look at higher margins, albeit with higher risk. The trick is in finding the most appropriate asset to meet the risk and return requirements. There are myriad income options available, including government and corporate bonds, hybrid securities, cash and term deposits, mortgage funds and residential mortgage backed securities to name a few. All come with varying profiles, whether it be credit exposure, probability of default, level of liquidity or coupon rate.
While finding the right asset to invest in is important, an equally important but often overlooked factor is the after tax performance of those assets. Unlike assets such as equities, which receive the benefits such as franking credits, income returns from cash and fixed interest assets do not typically enjoy these benefits.
Generally speaking, income generated from cash and fixed interest assets is treated as personally assessable income, and taxed at an investor’s marginal tax rate. While investment vehicles such as superannuation funds provide tax relief, the downside to these vehicles can be: (1) the investment is typically locked away until retirement age; and (2) there are limits on the amounts that can be contributed without significant penalties. Recent Government announcements on proposed changes to Superannuation policy have also caused a rethink of Superannuation for wealth accumulation, particularly where higher account balances and higher levels of ongoing contributions are concerned.
Another potential solution is the use of annuities, where typically a regular fixed amount is paid over a pre-agreed term or the lifetime of the investor. While there are tax benefits to be had by using an annuity (if purchased with super money no tax is payable from age 60 years, and a 15% tax offset applies if purchased with super money ) as well as a guaranteed income stream, there are down sides to consider. These typically include lower returns compared to investment-linked investments, low or no transparency about the assets underlying the annuity product, the inability to withdraw a lump sum, and the counterparty risk of relying on an annuity provider being around for the duration of the annuity.
An often overlooked, but effective alternative investment vehicle to improve after tax returns is to hold income and yield exposure via an investment in an investment-linked insurance bond structure. The primary benefit of insurance bonds is the maximum tax rate of 30% at which income within the insurance bond is taxed, irrespective of the underlying marginal tax rate of the investor.
Insurance bonds typically provide investors with the ability to make withdrawals without restrictions. Insurance bonds also typically have no limitations placed on the amount that can be initially contributed (although to maintain the investment’s tax status further annual contributions are limited to 125% of the previous year’s contributions…this is known as the 125% rule).
An insurance bond’s beneficial tax status as a shelter against personal tax is maximised after being held for more than 10 years. With recent Government’s proposed changes to Superannuation, we may see more of a focus on insurance bonds as a wealth accumulation vehicle.
The good news is that investment-linked insurance bonds typically provide a good range of yield generating investment options including plain vanilla options such as cash, Australian and international fixed interest funds. Other investment options that may be available include hybrid securities, mortgages, term deposit funds and credit funds.