Since the inception of the Covid-19 pandemic in March 2020 and more recently the war between Russia and Ukraine and general geopolitical tensions, markets have been very volatile, causing emotional and risk-averse investors to look for safer/lower-risk investment alternatives.
As a consequence, many investors have been selling out of stock markets and transferring their capital to money market investments. However, the real returns offered by money market investments simply cannot beat inflation at current levels of 5.70% whilst the interest rate in South Africa is a meager 4.75%.
An alternative investment option to money markets is income funds. Their objective is to provide a return higher than money market returns and to earn a reasonable level of income with relative capital stability and low risk.
These funds enjoy a flexible mandate, the fund managers will look for opportunities to invest in money market instruments, and different types of bonds such as inflation-linked, floating rate, fixed interest, preference shares, and property. Local 10-year bond rates are sitting at 9.875%, probably the most attractive bond market globally at the moment.
Interest rate risk –
The risk to which a portfolio or institution is exposed due to the uncertainty of future interest rates. Due to the interest rate sensitivity of bond prices, if rates rise, then the present value of a bond will fall. Interest rate risk thus refers to the effect of changes in the prevailing market rate on the return of a bond and comprises price and investment risk.
Inflation risks –
The risk is that when inflation rises it will lower the purchasing power of your income.
Credit risk – The risk that the creditworthiness of a bond issuer will deteriorate, increasing the required return on that bond and decreasing its value. Credit risk includes the risk of default, credit spread and downgrade risk.
Liquidity risk –
The risk in bonds is because of the difficulty of selling securities quickly at an attractive price. This only applies to the investor who is looking to sell their bonds before their maturity date. Investors who keep the bond until maturity will receive the principle of the bond plus interest on their face value.
Income funds should definitely be considered as part of an investment portfolio given the excellent risk-adjusted returns and lower volatility compared to other asset classes, especially while markets are so volatile. The percentage asset allocation to these funds will depend on the investor’s specific risk profile, income requirements, and time horizon.
If you are sitting on cash in the bank consider using an income fund to get you some kind of real return on your money instead of letting it sit in a fixed deposit or money market at the bank.