Maria Scott: Foolproofing your future income

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Recent problems prove that just because an investment is fixed-interest, it isn't risk-free

One of the cruel truths of the many recent investment disasters and disappointments is that they have been concentrated in investments used to provide income.

If you are relying on savings to produce money to pay the bills, this comes as a huge blow. Not only is income reduced, or even cut off, but you no longer have time, or the earning power, to recoup your losses.

Most of the pain has been felt by debenture holders in collapsed finance companies. But more recently, there have been the problems with two ING funds, the ING Regular Yield Fund and ING Diversified Yield Fund, both suspended, and Tower Investments' MortgagePlus Fund, which is to be wound up.

The problems all vary, though they have their roots in the credit crisis that took hold of international markets last year. Investors often fear shares because they see them as high-risk investments, but many have learned that risk also lies in other corners of the markets.

Least risky and probably the simplest is the cash deposit giving a fixed rate of return: a term deposit. The main risk here is that inflation, even at low levels, erodes the value of your deposit over time. There is also the risk that the company holding your deposit will go bust; a remote danger in the case of mainstream banks, but not unheard of.

Next up the complexity scale is a deposit with a finance company, where the risk of failure is not nearly so remote.

Further up the scale are bonds, a form of debt issued by governments, companies or local authorities.

Bonds are usually issued as tradeable securities, like shares, so their value can rise or fall. But if you buy a bond and hold it until it matures, you will know what your return is from the outset. If you sell before maturity, there could be a capital loss, or gain, as prices rise and fall. Prices in bond markets are influenced by movements in interest rates; if they go up, existing bonds tend to be seen as less desirable, and their value may fall. There is also the risk that the issuer of the bond could go out of business and default. If the bonds are bought from overseas, there is also a currency risk for New Zealand investors.

Cash and bonds are the mainstays of income investments but, depending on how your money is managed and who by, there can be wide variations, combinations and permutations.

Shares, property and loans may also be part of the mixture.

The ING funds that have been suspended were invested in collateralised debt obligations, known as CDOs, mixtures of bonds and debts from companies and residential mortgages. These types of investments have been caught up in the credit crisis and ING stopped buying and selling units because of uncertainties over pricing.

Steven Giannoulis, general manager, marketing at ING, says the two funds were at the higher-risk, higher-return end of the ING range of fixed interest investments. They were designed to be part of a diversified, long-term portfolio.

The ING funds were sold through advisers, including those with ANZ, co-owner of ING in New Zealand. ANZ has said that investors were properly advised of the risk involved, although anecdotal evidence suggests that not all investors fully understood what they had bought.

Mortgage funds, which produce income from mortgage repayments, have been another popular form of investment.

Phillip Gray, editorial and communications director with Morningstar Research, explains in a briefing paper that risks with mortgage funds include the possibility that a falling market could hit the value of the properties on which the fund had loaned money.

Funds with higher proportions of second mortgages are more risky than those weighted towards first mortgages.

Mortgage funds are also susceptible to movements in interest rates.

Today's high interest rates have been a factor in Tower Investments deciding to wind up its MortgagePlus Fund. Sam Stubbs, chief executive of Tower, says the fund could not compete with the rates on offer for bank deposits.

The company will make its first capital payment from the MortgagePlus fund on May 16, he says, and winding up is proceeding in an orderly manner.

With the high interest rates now available from major banks, why bother with anything more complex?

Investment management specialists point to the need to protect against inflation by building some capital growth into investment over the long term.

Cameron Watson, chief investment officer at ABN Amro Craigs, says: "Investors need to think long term and hold growth assets - property and shares - for the potential for income growth, especially in these times of increasing inflation.

"The trap some income investors fall into is focusing on today's income only and ignoring the income stream they will need in 10 or 20 years' time. Growth in income is vital; that's where shares and property come in."

Roger Browne, senior client adviser at Gareth Morgan Investments, says investors must also look at management fees on any investment they choose, especially when the returns from income investments are low.

"If you take management fees off and inflation, you can get zero return."

However Grant Hassell, head of fixed interest investments at AMP Capital Investors, argues that funds allow investors with smaller sums to diversify their investments.

Over time, returns will be greater than on a term deposit. As well, the 30 per cent tax cap on income from PIE-status funds improves their position versus other investments for 33 per cent and 39 per cent tax payers. "Personally, I think income funds will replace term deposits one day."

Hassell says that where finance companies were the investment of choice for many income-seeking investors, the temptation now will be to stick to cash term deposits.

"The right place is somewhere in between, but [in] a fund that is diversified and liquid."

Before you invest

Phillip Gray, of Morningstar, offers some tips on assessing income funds

* Higher-returning income products do carry more risk and should be assessed on the basis of how the investment manager is seeking to manage that risk.

* Just because a new product sounds different, doesn't mean it can escape the ups and downs of investment markets.

* The level of diversification within different income funds can vary substantially and can be lowest where needed most. This is particularly the case for newer products investing in a narrow part of the income securities market.

* Different income funds will behave differently in different conditions, highlighting the need for diversification in any portfolio.

* The regular income payments from mortgage funds are attractive but don't always reflect the risks beneath the surface.

* Don't let high returns fool you into forgetting the basics. Combining funds from a range of income product groups and managers helps diversify the overall portfolio.

Maria Scott is a Christchurch journalist who specialises in personal finance

- NZ Herald

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