Most conservative fixed interest investors find themselves in a position where the overall yield on their investment portfolio is declining through time. This is because investments made several years ago (when interest rates and credit margins were much greater than they are now) are maturing and the opportunities to re-invest those monies at the same rates are not available in the current market.
For nearly all Amicus clients, their overall investment portfolio yield is still higher than the investment opportunities in the current market and their portfolio performance relative to peers and to benchmark has been maintained over the last few years. However, going forward with the benchmark Bank Bill Index now close to zero (and it is unlikely to go negative), performance is likely to decline both in absolute terms and relative to benchmark unless progressive strategies are implemented
Average portfolio yields can be maintained if investors are willing to take more risk and buy fixed rate five year notes such as 5 Year Northern Territory Treasury Corp Bonds (at a yield of 1.35% after rebates of 25bps agency fees upfront from Amicus). There are several risks in executing such a strategy including an effective interest rate of 1.35% looking like an attractive yield in today’s environment, but if interest rates rise then 1.35% potentially looking like a paltry yield as it did a few years ago! There are also market and liquidity risks in that if the investment needs to be sold prior to maturity (as the cash is needed) a capital loss may be incurred if interest rates have risen and 1.35% is below the market rate. This could obviously also act the other way with a capital gain if a yield of 1.35% is above the market rate going forward!
The positives of such a strategy are the yield of 1.35% is “locked in” and it immediately addresses the declining average yield of the current portfolio (absent a default by the Northern Territory Government and having to sell the note prior to maturity). The alternative is perhaps simply investing in shorter dated term deposits and accepting overall portfolio yields are going to fall.
Another relevant factor is if the investment portfolio already has a longer average duration (because longer dated assets have been purchased previously as is the case for most Amicus clients) the declines in average yield are far gentler as less of the portfolio as a percentage needs to be re-invested each month at the new currently lower rates. This is a positive attribute when interest rates have declined, but it is a negative when rates have risen.
To illustrate these two effects of re-invesment choices and existing portfolio duration the graph below shows the projected average yield on two idealised portfolios. The first portfolio is a longer duration one and the second a shorter duration one, with the two portfolios broadly spanning the range within which nearly all Amicus clients currently fall. The longer duration portfolio has an average current yield of 1.35% on a 12 month rolling basis reflecting the prior purchase of assets at more favourable rates that have not yet matured and are still within the portfolio. The shorter duration one with an average yield of 0.65% broadly represents portfolios where all the assets have been purchased more recently at lower yields and any many previously high yielding assets have already matured.
Finance managers for both portfolios face a choice, which is whether to invest in 100% TDs (as the shorter duration investor has in the past) or to invest in 40% TDs and 60% longer duration assets (as the longer duration investor as in the past).
The average portfolio yield (over the previous 12 months) changes far more slowly for the longer duration portfolio (in brown). However, the cumulative choices whether to execute a strategy to invest solely in lower yielding TD’s or to maintain a proportion of assets in higher yielding longer duration assets has an increasingly marked effect overtime.
For the shorter duration portfolio (in blue), the investment choices made today have a larger effect more quickly because of the higher re-investment rate. A small change to the current strategy to invest 20% of new monies in longer duration assets can be used to maintain current portfolio yields, whereas the continuance with the prior strategy of 100% TDs leads to progressively lower yields.
The point of this illustration is to show if investment opportunities do not vary significantly from those currently available, the dominant factors which are going to determine the average investment portfolio yield going forward are the composition of the current investment portfolio in terms of the duration of its existing assets and the investment strategy adopted for re-investing cash from maturing investments.
Amicus welcomes enquiries from non-clients as to how they can better optimise their conservative fixed income investment portfolio performance going forward as this is at the centre of Amicus business.