Low interest rates pose challenge for investors - Novare

While some analysts had predicted the end of the current declining interest rate cycle, SA bond yields fell to a record low on speculation the central bank might cut interest rates after retail sales grew at the slowest pace in two years.

Ronnie Retief, head of multi-manager portfolios and unit trust fund of funds at Novare Investments, commented that the more conservative portfolios investors use for their income requirements typically have lower targeted returns and lower risk profiles.

A challenge to achieve real returns

"Given the objective to limit negative returns over shorter periods, a portfolio that targets around CPI plus 2% typically consists of mainly fixed interest instruments. During normal rate cycles this is achieved by investing in the money market, nominal bonds, inflation-linked bonds and various credit instruments. Many investors rely solely on money market funds, which invest at the short end of the interest rate curve," Retief said.

In the current environment it has become considerably more challenging to achieve real returns, with cash delivering negative returns as short-term interest rates yield less than the prevailing inflation rate.

Retief explained that cash rates falling below inflation are indicative of the financial crisis and central banks cutting lending rates aggressively to try and avoid recession. In the period post 1990, cash rates were never in negative real territory for long before a normalisation occurred. The last ten years has been a period of high real interest rates with the period from 2002 to 2008 delivering real cash rates of in excess of 2% for most of the time.

Interest rates can stay low for longer

"Currently, however, we find ourselves in a cyclically low period for interest rates that could continue for some time. Our long-term interest rates, represented by the notional ten-year government bond, are also in cyclically low territory. While it is not uncommon for interest rates to be low compared to their long term averages, what is concerning is the possibility that the situation could continue for longer than in the past due to the magnitude of the financial crisis we have endured and that persists in Europe and to a lesser extent the US," said Retief.

The problem this introduces is that investors cannot rely on money market instruments to provide real returns, and if they are drawing income from a portfolio yielding a negative real return, they will increasingly be drawing down on their capital.

"A viable alternative is to diversify into a wide range of fixed interest instruments in conjunction with some property and protected equity exposure. This would provide enhanced yield at a volatility level similar to that of a money market portfolio. Given the nature of the portfolio as a source of income, any exposure to equity should be hedged to ensure that the overall portfolio preserves capital, even during adverse markets," Retief concluded.