Surviving the new era of low yields

WITH global yields plunging dramatically after the Brits voted to leave the European Union in end-June, investors have yet another headache on their hands.

It will become harder to find financial instruments that will yield anything at all, for a reasonable amount of risk.

Low yields will become one of the biggest financial problems for savers and retirees in this generation.

A simple exercise will demonstrate this. Around 20 years ago, you could have S$100,000 in the bank generating 5 per cent a year, or S$400 every month, which is enough to cover basic food spending.

But if the interest rate is one per cent, you are looking at just S$80 a month. If you are counting on your old investment strategy to work, good luck. You now need five times as much money.

This doesn't mean there is no point to saving, as S$100,000 can last you many years if you live simply.

Nevertheless, our assumptions on saving and investing need to change.

Here are some tips for investors to survive a low yield world.

Take advantage of Singapore Savings Bonds

One can see the extent of the thirst of yield in the recent rally of the safest of investments, the Singapore 10-year bond.

Those who bought the latest benchmark issue of 2.125 per cent bonds at par, issued at the beginning of last month, would be sitting on a 4 per cent capital gain as at July 11. That's not bad at all for a one-month holding period.

If you are not already in yield instruments, however, a decline in yields is bad news.

Nine trading days into July, the benchmark 10-year bond is yielding an average of around 1.75 per cent, down from an average of 2.03 per cent in June.

However, there is still one way to get that 2.03 per cent June yield.

You can buy the July subscription of Singapore Savings Bonds (SSB), to be issued on Aug 1.

You can "game the system" due to a natural delay in how SSBs are priced and issued.

The Aug 1 bonds are priced off June yields. Similarly, the Sept 1 bonds, open for subscription in August, will be priced off the relatively less attractive July yields.

Assuming yields stay at the 1.75 per cent average for the rest of the month, buy-and-hold investors can get 0.28 percentage point more of yield by subscribing for the SSBs in July instead of the 10-year bond at current prices.

For a S$50,000 portfolio held over 10 years, this works out to an extra S$1,400 in total.

The difference might seem small, but in the search for yield, every dollar counts.

Similarly, if yields suddenly go up in the course of the month, investors need not rush into this month's SSB subscriptions, for a better deal will come out the following month.

Of course, there is a maximum individual holding of S$100,000 for the SSBs. For wealthier investors, the quirk of SSB issuances highlighted here works out to small change at best.

Yet it is nice to know there is a way to get a better yield than the market is offering.

The biggest advantage for SSBs lies in their flexibility. You can redeem your bonds at any time and get back your principal the following month, with accrued interest.

So if you are not feeling adventurous, feel free to park your extra cash in SSBs. Get the yield while it lasts.

Be wary of endowment plans

A low yield environment is caused by weak economic growth around the world.

As inflation likely remains low in this situation, the arguments made by financial advisers to invest your money somewhere ("Do you want to lose your money to inflation by leaving it lying uselessly in the bank?") carry much less weight.

In this environment, insurers, too, won't be able to package attractive endowment products. The 4.75 per cent assumed returns used for insurers' benefit illustrations, already lowered from 5.25 per cent in 2013, now seems laughably high.

Yet should they illustrate their endowment policies with a 2 or 3 per cent rate of return, as seems more realistic, nobody would find the products attractive.

Not when the Central Provident Fund (CPF), for one, is still offering 4 to 5 per cent on its special accounts meant for retirement needs.

Young professionals have to be careful when pitched new insurance and endowment products that they can only withdraw without penalties 30 or 40 years later.

More often than not, they end up regretting their commitment.

Endowment payment obligations become onerous if you have other cashflow needs, or if you are temporarily unemployed.

Monies from endowment policies are typically invested in a portfolio that includes safer government bonds.

Yet these government bonds are yielding just one per cent or under in many parts of the developed world. In some cases, yields have been pushed into negative territory by central banks trying to stimulate bank lending and growth.

Endowment portfolios will also be invested in riskier assets like high-yield corporate bonds, emerging market bonds or even stocks.

Risk entails the possibility of loss. An insurer will not be able to stomach excessive risk.

So they either end up buying higher-yielding assets and running the risk of losses, or sticking to low-yielding safer bonds. Either way, it is likely insurers have to lower their bonus payouts.

This is not to say these products are completely useless. If you cannot be disciplined about your saving, for example, locking yourself into a hefty long-term commitment might actually work out.

Otherwise, you might be better off just separating your assets into a low-cost bond index tracker and a low-cost equity index tracker, which might replicate what the endowment is doing at a far lower cost. You can find their asset allocation in their documents.

Be realistic about compound interest

Low yields challenge another tenet of personal finance, which is the role of compound interest.

Hundreds of retire-rich quick books written in higher-rate days all operate on the premise that money, allowed to snowball over time, can lead to a fortune.

But we've explained a quirk of compound interest before in a previous column. Money only really accumulates in the last few years of your forecast horizon.

Now with falling yields, the magic of compound interest will be sharply curtailed.

Put simply, you might once have counted on compound interest to make your millions. Not any more.

Perhaps this low yield world is just a blip in the Matrix that will be corrected and forgotten 10 years from now.

But yields have been falling for 30 years and mean reversion is nowhere in sight.

Build on your skills

So more effort has to be made on generating income and saving it, rather than relying on compound interest to work for you.

Personal finance planning goes beyond figuring out what to buy and where to allocate your assets.

Rather, employees have to think about what skills they have and what they need to learn so they can remain relevant and competitive.

The "side hustle", slang for a way to make extra money on the side on top of a day job, can become more important.

With the help of the Internet, side hustles should theoretically be easier to find - though the price of a routine job will fall.

In Singapore, the typical side hustle for university graduates is to give tuition. Other side hustles can be found, like babysitting, photography, or teaching subjects like swimming, a sport, art, or music.

Ideally, these part-time jobs should be something you are passionate about. You can then spend your off-work hours doing something you love, with the pocket money a bonus.

Be aware of market risk

Stocks are volatile and you need to have the stomach to hold them. To understand risk, educate yourself on the nature of what you are buying.

Even blue chip stocks offer market risks. The three local banks are a good example. DBS Bank was trading at S$20 a share just a year ago.

Today, it is down 20 per cent to around S$16. The dividend yield of 3-4 per cent is not enough to cover your paper losses.

Bank fortunes are closely tied to the economic cycle. When the cycle slows, like now, they will not do well. Also, banks consist of many thousands of loans. It is not likely that investors have the knowledge on the risks lenders have taken with the companies they lent to.

Of course, those with a longer time horizon can average into stocks with sound balance sheets and operating businesses which hold the promise of growth.

But it might be a long and wild ride, and investors have to be psychologically prepared.

Don't jump for yield

In a low-yield world, investment opportunities will spring up offering you seemingly high yield for little risk.

These can include low-volatility, high-income funds where a bit of financial engineering is involved to generate an extra yield.

One popular method involves selling call options on stable blue chip stocks. This essentially leads to a steady side income of 1-2 per cent a year if the stock trades in a range.

If the stock appreciates beyond an upper limit, the call option kicks in. The stock will be sold, netting a fixed profit. But the problem with this is that you might miss out on a significant rally of the stock.

And if the stock falls in price, the income you make from selling the call option is unlikely to make up for the loss in value.

So selling calls can be a limited way to make a little bit of money at best. And in the meantime, you might be paying a fee of more than one per cent a year on the fund.

As long as you are buying a stock fund, you will be facing market risk, which is the risk of your assets dropping in price due to market fluctuations.

Bond risks

Bond funds might seem attractive in an environment of declining rates, but one has to be aware of pricing and liquidity risks in certain corporate bond issues.

In many cases, corporate bonds are not traded that frequently. In the event of a global interest rate rise and everyone is rushing to get out, prices will fall pretty fast.

Meanwhile, more companies will take advantage of the low interest rate environment to issue bonds to retail investors.

In some cases, the yields can be attractive, like 5 per cent or more.

Examine the company carefully. Some companies raising funds are heavily indebted, or conduct businesses that are extremely cyclical in nature.

Avoid lending money to these companies. Learn from investors who bought the bonds of some energy-linked companies which are now having trouble repaying their debt.

Even if they want to get out, they might have trouble finding buyers, and have to offer a bigger discount.

Read up

Meanwhile, foreign property might seem enticing due to higher yields, until you realise you have to deal with a possibly uncertain legal environment, as well as currency fluctuations.

Investment schemes abound in precious metals, peer-to-peer lending, landbanking, even movie scripts.

You've worked so hard for your cash, so don't lose it to greed.

Ultimately, to generate financial returns in a low yield world, investors have to be even more canny about risk assessment.

For some, it might be more worthwhile to stick their money in the safest bonds, no matter how low-yielding, and focus their energies on making their skills more relevant to the market to earn a higher income.

For those with an interest in financial markets, there will always be opportunities.

Being able to sniff them out comes down to plenty of hard work in researching individual companies, or understanding macroeconomic data and trends.

For example, certain stocks and sectors, like industrials or resources, are cheap right now. Value investors can evaluate them, get a position, and wait for the economic cycle to turn.

Other stocks are not cheap, but can still keep growing to justify their pricey valuations. This includes even some pricey consumer staples stocks.

There are no short-cuts. And with the Internet, a lot more information is available than before. Investors just need to do the work.

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