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Are income funds risk free?

There are several risks a management team must consider when constructing a portfolio of income-yielding instruments.

Cash has become the ‘safe haven’ for investors who have opted out of multi-asset funds due to the poor return of growth assets over the past several years. Some investors have chosen to remove the uncertainty of noisy volatile markets and secure the “certainty” of an inflation-beating return with a relatively low degree of volatility.

Income funds have become the refuge of choice for many anxious investors. The graph below shows the net inflows into income funds over the past three years, as represented by the blue portion of the bars.

This raises the question of whether investors understand the risks which are associated with income funds, or do they simply pick the highest-yielding income fund in the market with the assumption that, for the most part, income funds carry the same risk across the board?

What are the risks?

There are several risks which must be considered by a management team when constructing a portfolio of income yielding instruments. The three types of risks which one must understand are as follows:

Credit and duration risk: 

The graph below shows the yield on the Y-axis and the duration on the X-axis. The different coloured lines represent instruments of different quality ratings. The red line is an AAA-rated instrument which is the highest quality rating. As you can see from the graph the AAA-rated instrument gives a lower yield in comparison to the other instruments with a lower quality rating. This refers to credit risk. The higher the risk to the creditor, the higher the yield must be to compensate for the added risk.

Duration risk is fairly simple to understand at face value. Once again, the graph above shows how the longer the duration, the higher the yield must be. The investor is taking the risk that over the longer period to maturity there is a greater risk that an unfavourable outcome could occur.

This speaks to underlying issues within credit and duration risk, namely default risk, spread risk and liquidity risk. Without boring readers as to the technical aspects underlying these particular risks, one simply needs to know that the higher the yield that is offered, the higher the potential risk to investors. At least that’s the theory.

The table below shows the instrument in the first column, the yield in the second column and the typical issuer of the instrument in the third column. In short, it once again illustrates that the higher the yield the higher the risk and the lower the liquidity.

Inflation risk

The risk of inflation means that investors need to achieve a minimum return equal to that of inflation net of tax and management fees for their capital to maintain its purchasing power over time. Traditionally, income instruments such as cash don’t offer a high real return. The challenge for income funds is to generate a real return of inflation + 2% net of cost, without taking a high degree of risk.

The graph below shows the yield on the Y-axis and the duration on the X-axis. The blue dots represent the Prescient Income Provider Fund while the red dots represent the All Bond Index. As you can see the Prescient Income Provider Fund has a similar yield to that of the All Bond Index, however, it has a much shorter duration (i.e. lower risk).

This illustrates how a quality income fund can mitigate risk whilst delivering an attractive real yield.

The table below shows the disparity in the annualised five-year return from the multi-asset income fund sector. Note that inflation-linked bond funds, which are included in the sector, have been removed for the illustration.

 

5-year annualised return

3-year annualised return

1-year return

Highest return

10.17%

11.29%

13.53%

Lowest return

5.25%

5.01%

1.67%

Sector average return

7.65%

7.73%

8.12%

Inflation (CPI)

4.92%

4.55%

3.96%

Source: Moneymate and Morningstar, August 2019

Investors must be aware of the risk associated with income funds as they may carry differing degrees of risk which may be unbeknown to the investor.

Investors should consider using independent financial advisors to assist them in achieving their financial goals through an integrated financial plan which considers the risks to investors which they may be unaware of, such as those within income funds.

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Jesse Morgans

Asset Protection International

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