Canny View: Don't overlook risk in search of returns

High yield can look attractive, but what lies beneath? Photo / Supplied

Record low interest rates in Australia and New Zealand are tempting yield-seeking investors into products where the risks can be obscured.

New products often are marketed as solid, cash-like instruments that offer regular, predictable returns. But we've seen this movie before.

Think back to 2007. With interest rates low around the globe (but not as low as now), the then governor of the Reserve Bank of Australia, Glenn Stevens, warned that in the search for yield, many investors were unwittingly straying out to the frontiers of risk.

"A long period of interest rates being low and fairly steady, however well justified it might apparently be by short-term macroeconomic fundamentals, also causes behaviour to change," Stevens said in a speech in Hong Kong.

"The search for yield eventually explores some fairly remote territory – be it more pension fund or retail money going into hedge funds, the rise of private equity funds, or the use of ever more exotic strategies by various managers to generate returns."

Now in Australia, New Zealand and elsewhere, we again see ads for products that appear to blur the line between traditional bank deposits and risky property loans. Credit funds, hybrids, high-yield bonds and private debt are pitched in glossy ads at investors who formerly might have kept a chunk of their savings in term deposits.

Ironically, this slick marketing is appearing just as some people whose money was stuck in frozen funds a decade ago finally emerge from the wreckage. For instance, one Queensland-based mortgage income-fund recently paid its first distribution since it went bust in 2008.

This isn't to say another crisis is around the corner, but it does serve as a reminder that during periods of very low interest rates, as we are seeing now, yield-deprived investors can overlook risk in their scramble for return.

The truth is higher yield does not come free. It is the flipside of different types of risk, some of which may be hard to quantify. This can include credit risk – the chance of the issuer defaulting on their obligations – or illiquidity, where it is hard to get your money out.

Of course, not all these advertised products are inherently bad. But it's worth talking through with your adviser about whether they are appropriate for you, given your circumstances, goals and risk appetite. A bank deposit and a mortgage fund are not equivalent beasts.

Nick Stewart

There also may be other choices you can make that don't leave you out on the frontier of risk without a compass to get back home.

One choice is to take on more diversified exposure in global shares and target the parts of the market that offer higher expected returns. Yes, there are risks here as well, but you can cushion that by being highly diversified.

If you really don't want to bear additional risk, there is also the choice of moderating your consumption expectations. This obviously can involve some difficult decisions, but if it allows you to sleep better at night it may be worth it.

Wanting additional income is understandable. But you need to be wary about some of the promises being made by product manufacturers who are taking advantage of the low interest rate environment and of the appetite for yield.

Ultimately, your best option is talking this over with your adviser, assessing your asset allocation and seeing what choices you have available without taking you to uncomfortable areas.

On the surface, high yield can look attractive, but you always have to ask what lies beneath.

Nick Stewart is an Authorised Financial Advisers and CEO at Stewart Group, A Hawke's Bay-based CEFEX certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, Wealth Management, Risk Insurance & KiwiSaver solutions.

This article is prepared in association with Dimensional Fund Advisors. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz