The most recent article I penned for Moneyweb was titled ‘The risk of being too cautious’ and spoke to investors holding too much cash or being spooked to cash by prevailing market conditions.
While I conveyed a view that was not supportive of excessive cash there will be investors who, for many reasons albeit right or wrong, hold a lot of cash. There are however several alternatives to cash-in-the-bank depending on your risk appetite and time horizon.
There are two money market options that come to mind; one offered through a bank and the other via a unit trust. Both options are relatively low risk but not no risk. An example of this is African Bank’s demise where some investors lost capital due to having exposure to the failed bank’s debt. Costs are typically low or non-existent but there could be transaction fees. Be mindful of investment minimums as well as tiered interest rates depending on the cash balance. Money market vehicles are typically liquid with the bank account option available immediately and the unit trust option available with a few days’ notice.
While the rate on the two options under discussion is similar, currently more than 7%, there are different risks you must familiarise yourself with such as the credit (balance sheet) risk with bank option and the credit risk (underlying issuers) in a money market unit trust. A tell-tale sign of a product taking on additional credit risk is a rate offered that is materially higher than competitors; the worse the credit risk the higher the chance of a default and thus potential capital loss. The interest earned is subject to tax and it is the after-tax rate that you need to compare when weighing up the alternatives.
A last point on money market is that certain unit trust management companies offer foreign currency money market alternatives. Historically, when converted to Rands, foreign money market has been the most volatile asset class in which to invest (think about the swings in the exchange rate over time).
Flexible income funds
There are a broad range of income-type unit trusts available, ranging from cash-plus to long term bond funds. I will focus on the multi-asset income sector which has some unit trusts worth considering for someone with a medium-term investment holding period. Multi Asset Income funds can invest in bonds, fixed deposits, money-market instruments, property shares (up to 25%), preference shares and other high-yield stocks (up to 10%). Some of the funds can also invest up to 25% of their assets offshore.
Due to the potential capital volatility of these funds they are ideal when the holding period is at least 18-24 months. From a tax perspective, most of the return is earned by way of interest type income and over time there should also be some capital gain.
One important thing to look out for in Income Funds is the duration of the fund. Simplistically, the duration represents the average maturity of the fixed income assets (bonds, NCDs, floating rate notes etc.) in the portfolio. The higher the duration the more sensitive the capital value of the instrument is to changes in interest rates. An asset with a duration of ‘five’ will move inversely by 5% to a 1% change in interest rates.
Another important risk, when looking at almost any income producing asset, is credit risk. If an issuer is seen to be risky it needs to offer its debt at a higher yield to make it attractive to the market; the higher the risk the higher the return and the higher the chance of default. At the time of writing this there are several flexible fixed income funds with yields above 8.5%. The yield is attractive but don’t forget Income Tax which will reduce the gross return. There could also be a capital loss or gain.
Listed preference shares
A preference share is a share which entitles the holder to a fixed dividend, whose payment takes priority over dividends to ordinary shareholders. The shares can be redeemable or perpetual and will typically trade at a premium or discount to its issue price throughout its life. The dividend is classically expressed as a percentage of the prime rate. Preference shares can provide a nice income/dividend stream and are usually best suited to people with high average tax rates when comparing the net after tax return to other alternatives.
Dividends attract Dividends Withholding Tax (DWT) at 20%. Preference shares from several issuers are available with different credit risk which dictates the percentage of prime offered. The worse the credit the better the participation rate. Dividends are typically paid semi-annually and you could buy a variety of shares from different issuers to stagger the dividend receipt.
One of the considerations when buying preference shares is liquidity as it may take a while to sell a meaningful holding. In the current market a lot of preference shares are trading below par; an example being the Nedbank Preference Share which based on information at the time of writing has the following attributes:
- Dividend equal to 83.3% of prime
- Effective rate of 8.7% (7.8% net)
- Yield of 9.7%
- When the yield is higher than the coupon it tells you that the counter is trading at a discount
You also get unlisted preference shares where the capital value (share price) remains constant through the term. There are unit trust alternatives that invest in unlisted preference shares which is a good way to gain exposure with no liquidity constraints.
Another advantage of the unit trust option is accessibility and diversification for smaller investment amounts as unlisted preference shares are often sold in large value bundles. An unlisted preference share has the same tax efficiency as a listed preference share however with no capital volatility. As always, ‘caveat emptor’.
This option has the longest lock-in compared to any of the other solutions I have mentioned. You invest for a term of five years and you can usually get intra-term liquidity although the guarantee will not apply in this instance. Guaranteed endowments pay investors a fixed return over the investment term after which the capital is returned to the investor. The return can either capitalise over the term or pay out as an ‘income’ during the five-year period.
Current yields (after-tax and costs) are approximately 6.4% (equivalent to an interest rate of 11.64% for a 45% tax payer) for a guaranteed growth endowment and around 6.3% (of which the taxable portion is approximately 15%) for the income option. You are locked in to a rate for a fixed term, if interest rates move up you could end up with an opportunity cost by being locked in to a rate lower than the market. One could argue that this is especially relevant in South Africa now as a series of downgrades could significantly push up long-term rates.
It is most often in difficult market environments like that in which we currently find ourselves, when the scammers emerge. If it sounds too good to be true please walk away. It is important to maximise your return while considering the possible dangers being the possibility of not getting back some or, in a worst-case scenario, all your money.
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