Tapping into your investments as an income
Whether you’re saving to pay for your children’s education, take a break from work, or even to have more spending money in retirement, setting a plan in motion so you can draw an income from your investments could make that goal a reality. What type of funds should you be looking at that will help you generate an income that’s higher than a simple bank deposit over time?
“Enhanced income”-type funds are those that aim to deliver a high level of regular income that will beat a cash or money market return over two to three years. How do they do this? These funds invest in a combination of assets that give you both 1) a steady income stream, and 2) some capital growth over time. This comprises a high proportion of assets like cash and bonds for income, as well as a smaller amount of growth assets like listed property and even some equity.
Because some equity and property holdings are included, enhanced income funds are riskier than cash or money market funds. Over the past year or so, we’ve seen that most assets have produced relatively low or negative returns, including bonds. This has reduced the returns delivered by enhanced income funds. One of the reasons for negative bond returns has been the rising interest rate cycle in South Africa: higher interest rates erode the capital value of fixed-rate bonds. Historically it has been shown that when the South African Reserve Bank is hiking interest rates, bond returns decline over the short term, before improving again as interest rates stabilise and eventually fall.
Partly because of their high bond holdings, returns from enhanced income funds reflect the interest rate cycle. They do comfortably outperform money market and cash returns over periods of two to three years and longer, but there are shorter-term periods (one year or less) in which they are expected to underperform, and do so. Longer-term investors are rewarded for this risk.
This is why we believe it is important for enhanced income investors to have an investment horizon of between one and three years. We view this timeframe as essential in achieving the additional returns over cash.
During periods of temporary underperformance, we have seen investors make the mistake of switching away from their enhanced income fund to money market funds or a one- or two-year bank deposit offering slightly higher future returns. There are two risks with this strategy: first, investors lock in the short-term underperformance. Second, when the bank deposit reaches maturity after one or two years, the interest rate cycle will have turned so that rates will be falling – the investor will have missed out on potential gains from the enhanced income fund and will be forced to move out of the bank deposit and reinvest at lower rates. This “reinvestment risk” needs to be taken into consideration.
Consequently, even though it may be tempting to switch, income investors should try to weather the short-term relative underperformance and stick with enhanced income funds. In the end, steady investors should be rewarded with a higher return than from a bank or cash deposit, helping them achieve their savings goal.