By the end of this year income from cash investments is expected to fall by 30% as interest rates are cut. The only consolation to South Africans dependent on interest income is that they do not live in the United States, where rates have been cut to zero.
Nevertheless, investors need to start looking outside cash investments if they don’t want their income to be cut too dramatically. Participation bonds, which over time outperform money market funds by about 1.5% per annum, could be an effective way to replace lost income. Absa and FedGroup are the two leading players in this market.
Investors in participation bonds effectively participate in the mortgage bonds of commercial property. The fund uses the pool of investors’ money to provide loans for commercial property and the investors participate in the returns on that mortgage.
The yields are above that of a money market fund. For example, since the launch of unit trust money market funds, FedGroup’s participation bonds have outperformed money markets by 1.5% to 2% per annum on average. They has also kept in line with inflation. Scott Field, FedGroup’s group operations officer, says that in the past five years the FedGroup Managed Participation Bond has delivered an accumulative return of 48.61% compared with CPI of 32.23%.
Yield
The Managed Participation Bond pays a yield of 11%, while the FedGroup Care Fund for people over the age of 55 pays a yield of 11.5%. These yields are nominal and net of costs. A person over the age of 55 with R100 000 invested would receive R958 a month. The yield fluctuates with interest rate moves, so if rates are cut by 100 basis points the yield will fall by the same amount. But clients are given a three-month notice period before rates are adjusted.
This provides the client with time to plan for the change in income. This means that, based on the two rate cuts we have seen so far this year, by July the yield will have fallen to 9% and 9.5% respectively. But clients have the benefit of the higher rate for an additional three months during a rate-cutting cycle.
Investment period
Participation bonds are a five-year investment with income paid monthly in advance. The capital is repaid at the end of the period. The investor can opt to re-invest the income. Although it is a fixed five-year investment, if the client wants to withdraw the funds earlier, most funds will buy back the investment, although an early withdrawal fee will be charged. In the case of Absa PartBond Investments a 2% fee excluding VAT is levied on investments withdrawn before three years.
Risk
Participation bonds received bad press in 2000 when Fedsure’s PartBond was suspended by the Financial Services Board. This was because the major shareholder, Fedsure, collapsed and the FSB undertook a thorough investigation of the subsidiary. For two years the fund was prevented from paying out interest.
But after investigation the fund was given a clean bill of health, resumed business and is now fully owned by FedGroup. No investors lost money and were paid out all capital and interest. “In the 19 years of the fund’s history we have never lost a cent of clients’ capital or interest,” says Field.
Participation bonds fall under the Collective Investment Schemes Act and are well regulated. The investment is underpinned by a real asset belonging to the investors, so even if the fund manager had to disappear the fund could be transferred to another manager without any losses.
But there is some risk in the underlying asset, which is effectively a mortgage bond with property as collateral. If the commercial property sector had to collapse there could be capital losses. This could occur if there was a major downturn in all property sectors and a large number of borrowers defaulted. To manage these risks the fund ensures that it is well diversified across sectors and regions. Loans are a maximum of 75% of the value of the property, so the property value would have to fall by more than 25%. The fund is also diversified over time, as some loans are already 10 years old, for example, and a high proportion of the loan has been repaid and the property value has increased.
FedGroup runs promotions with its Super Care fund, which pays an additional 1% yield. This yield is taken from company profits and is used to encourage new investors and allow existing investors whose funds have matured to invest for another five years at a higher yield. The fund is closed to new investments but will reopen towards the end of the year.
The three key yield factors
When looking to boost your income there are three key elements to consider — tax, costs and diversification.
Tax
Tax planning is critical to ensure you maximise the tax-free allowance on less risky investments first. If you are over the age of 65 you can receive up to R114 000 from interest income, tax free. Based on an interest rate of 9%, you can effectively invest nearly R1.3-million tax-free if you have no other income. This is based on the R84 500 tax threshold before you need to pay income tax, as well as the R30 000 tax exemption on interest income. This equates to R9 500 a month of tax-free income.
Costs
When comparing products you need to make sure you compare like with like. Scott Field, FedGroup’s group operations officer, says many money market unit trusts quote yield gross of fees. They also quote an effective rate as opposed to a nominal rate. For example, a top-performing money market fund produced a return over three years of 31.92%, but after costs and fees that return falls to 28.2%.
Before you invest in a product make sure you understand exactly how much income will actually reach your bank account. The two questions to ask are:
- What is the nominal rate? This is the actual interest rate without the compounding effect of re-investing your income. For example, a fund may quote a yield of 10.5% but the nominal rate, if you draw your income monthly, is actually 10%.
- What is the yield net of costs? The costs can include: total expense ratio is usually about 0.25% to 0.5% for money market funds, management fees, commission paid to the financial adviser and deposit fees. Make sure these costs are accounted for when calculating the real return.
Diversification
In the search for yield during these difficult times, one has to have a diversified income stream to minimise risk. It is important to remember that any income over the cash rate implies risk. Sunel Veldtman, director at BJM Private Client Services, recommends that income-sensitive investors with balanced portfolios include a mix of steady income-producing assets, such as money market, bonds, property and preference shares. Veldtman says BJM advises clients to move out of call accounts and into the money market. “We are also advising clients to start looking at replacing money market holdings with income funds since we’re expecting the rates to start coming off drastically.”