Since the inception of the Covid-19 pandemic in March 2020 and more recently the war between Russia and Ukraine, 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 meagre 4.25%.
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, different types of bonds such as inflation-linked, floating rate, fixed interest, preference shares and property.
What are the risks?
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.
When advisors include options like income funds in portfolios where appropriate, a popular fund used is the MI-Plan IP Enhanced Income fund, which has outperformed the JSE successfully and provided greater returns than equity over the past five years, and with much less volatility.
The MI-Plan IP Enhanced Income fund is a typical income fund that is used for investors seeking options in fixed income funds. The fund currently includes government bonds (42.59%), corporate bonds (55.32%), securitised (1.43%) and cash and cash equivalents (0.66%).
The fund’s superior performance compared to the JSE and South African interest-bearing money market over the past five years is illustrated graphically below:
In March 2020 South Africa experienced the sharpest correction in the local bond market in the past five years. Despite this downturn, investors were still able to receive a positive return.
Income funds should surely 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.