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Investing for Income Series: the fundamentals

In the first article of our Investing for Income Series, we explore the fundamentals of income-focused investing and how you can diversify your fixed income and cash investments in 2017.

The amount of income a self-managed super fund (SMSF) needs to generate is one of the enduring issues for all trustees to consider.
 
It’s something to think about when the fund is in accumulation phase. But it’s especially important for SMSF members in retirement as often they rely on the income their fund produces to meet their basic living needs.
 
There are a number of steps SMSF investors should take to ensure they are optimising the fund’s income potential: 
 

1. List your options 

There are many opportunities to invest for income. Before taking any decisions about the structure of the income component of your portfolio it’s essential to fully appreciate the universe of income-producing investments, their risk/reward profile and how they fit into your investment strategy and long-term investment goals. Think about options that are relevant to you, and create a list of each of their respective characteristics. 
 

2. Assess income potential for each investment 

Examine where the asset’s income is sourced from, the sustainability of its earnings and any risks to it.
 

3. Local versus global

Decide how much exposure you want to Australian versus international assets and how you can manage exposure to currency risk. 
 

4. Getting the right exposure

Choose how you will gain your exposure to income-producing assets. This involves determining the right balance between direct and listed investments, as well as the different types of managed funds that generate income.
 

5. Understand your risk tolerance 

Work out your risk profile as it relates to income-producing assets. Some investors will want to invest in assets that produce both capital growth and income. This lead them higher up the risk curve towards investments like shares that have the potential to deliver not just yield but also capital growth. 
 
Other investors will not want to take on this risk, and may prefer to invest in term deposits or fixed interest managed funds or exchange-traded funds (ETFs).
 
Damian Liddell, a financial adviser with Browell’s Financial Solutions, has some ideas for SMSF trustees about options for getting the right exposure to income-producing investments.
 
Often term deposits are the starting point. At the moment they offer extremely low interest rates, which SMSF investors should understand. They usually form part of the fund’s defensive assets. But how much depends on members’ circumstances. 
 
Too much exposure to term deposits risks the fund not meeting its investment goals, but not enough exposure may mean the fund is less able to withstand a serious market correction.
 
“The best thing to do is have term deposits maturing at different times throughout the year so that money isn’t locked away for too long,” he advises.
 
According to Liddell, the standard fixed income holding for an SMSF is a fixed income fund that is highly diversified. It should be diversified by location and have both Australian and international fixed interest assets. 
 
The type of assets it holds should also diversify the fund. For instance its investments should include government, semi-government and corporate bonds.
 

Interesting income ideas 

Term deposits, managed funds and shares that generate dividends are only some of the ways SMSFs can access income-producing investments. Liddell has some other ideas for trustees.
 
“On the cash side I’d be looking at savings products issued by online banks that typically pay a higher interest rate than the traditional banks because they have lower overheads, due to less infrastructure such as branch networks.” His advice is to take advantage of welcome or honeymoon introductory rates.
 
On the fixed income side Liddell says it’s important to remember there’s an inverse relationship between interest rates and bond prices.  When rates rise, bonds lose value.  “So look for funds with active management that focus on absolute returns – that is a positive return regardless of prevailing market conditions.”
 
“At the moment I particularly like unconstrained fixed income funds, as well as funds that have low or negative duration. Funds that are low duration are less sensitive to interest rate rises, therefore helping to protect capital.  And if a fund has negative duration it can actually appreciate in value if interest rates rise”, Liddell says.
 
Unconstrained income funds have choice about the type of assets and geographic regions that they invest in. Low duration funds attempt to blunt interest rate sensitivity by investing in bonds with shorter maturities - typically one to three years. 


Getting the right exposure 

Just how much exposure your fund should have to income producing assets depends largely on your view of interest rate movements here and overseas.
 
Says Liddell: “I think we’re getting to a point where growth assets are no longer cheap. So now may be a good time to consider increasing exposure to defensive assets such as income-producing investments. 
 
“But I would be a bit concerned about fixed income assets in a rising interest rate environment. So if you’re thinking about increasing your exposure to defensive assets I would suggest trustees consider cash, floating rate notes or an unconstrained fund manager,” he adds.
 
The right choice will depend on the fund’s investment strategy and its member’s long-term goals. 
 
Funds related to this article: Corporate Bond Fund

A diversified investment grade corporate bond portfolio providing access to a diversified pool of typically over 100 corporate bonds. The Fund aims to deliver to its investors a regular monthly income (which exceeds the income from term deposits and government bonds) whilst seeking to provide capital stability over the medium term.

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